When the price of a stock rises, the value of a call option increases. They are the most well-known type of option, and they let you lock in a price to buy a specific stock by a certain date. Call options are appealing because they can appreciate quickly if the stock price rises a little. As a result of this, they are popular with traders seeking a large profit.
Call option sellers, sometimes referred to as writers, sell call options in the hopes that they will expire worthlessly. They profit by pocketing the premiums (price) they are paid. If the option buyer exercises their own option profitably while the underlying security price increases over the option strike price, their profit will be diminished, and they may even lose money.
Call options can be purchased in two ways:
If the call option seller owns the underlying stock, the call option is covered. Selling call options on these underlying stocks generates additional money and offsets any predicted stock price decreases. The option seller is "protected" from a loss because if the option buyer exercises their option, the seller can furnish the buyer with shares of the stock that he has previously purchased at a lower price than the option's strike price. The seller's profit from owning the underlying stock is restricted to the stock's rise to the option strike price, but he is protected from any actual loss.
When the option seller sells the call option without owning the underlying stock, it is known as a naked call option. Since there is no limit on how high a stock's price could go and the option seller is not protected against potential losses by holding the underlying stock, naked short selling of options is regarded as exceedingly dangerous.
When the call option buyer exercises his right, the naked option seller is required to purchase the stock at market price and deliver the shares to the option holder. If the stock price exceeds the strike price of the call option, the seller will lose the difference between the spot market price and the strike price of it. To compensate for potential losses that may arise, most option sellers charge a high cost.
There is a call sold for every call purchased. So, what are the benefits of selling a call option? In other words - the payout structure for buying a call is exactly the opposite. Call sellers predict the stock to stay flat or fall, and they want to collect the premium without risk.
For instance, there is a stock ABC trading at 1,000 per share. You could sell a call on that stock with a 1,000 strike price for 200 with expiration in eight months. One contract would give you 20,000 (this is 200*1 contract*100 shares).
The payoff for the buyer would be exactly the opposite:
Selling calls has the advantage of receiving a cash premium upfront and not having to put money down right away. Then you wait till the stock is about to expire. You will profit if the stock drops, stays flat, or even climbs a little. However - unlike the call buyer, you would not be able to quadruple your money. The most you will make as a call vendor is the premium.
While selling a call may appear to be a low-risk strategy – and it often is – it can be one of the riskiest options strategies due to the possibility of limitless losses if the stock climbs.
Selling call options, like most types of investing, has both gains and downside. Earning additional (premium) income on the stock you currently own or stock you don't own is one of the benefits. You could sell a one-month covered call 12 times in a year if you repeat this action. Finally, the premium you receive is paid in advance and remains yours regardless of what happens.
On the negative side, premiums are limited, which limits profit potential. You can miss out on a huge upward movement in the underlying stock because you can't sell it without buying back the contract. Worst of all, your losses could be limitless depending on the sort of call option you sell.