Buying CALL OPTIONS on individual stocks or other types of securities can provide an affordable and flexible way to benefit from an anticipated stock price increase.
One of the major benefits of Stock Options is the ability to generate an income through buying and selling them. This is called Options Trading and profits are realised once you have sold an option for a higher price than the premium you initially paid for it in the first place.
But are you aware that you can actually Write or sell Stock Options and collect that premium as income?
You would write Call Options when you have a bearish view on a particular stock and there are two ways you can expose yourself to risk when doing so.
WRITING NAKED CALLS - A naked call is a CALL OPTION written or sold by an investor or trader who has no holding or position on the underlying security. In other words they do not own the stock in the first place.
You would write a naked call when you think the stock price will fall but you lack the funds to invest outright and short the stock, or you may just prefer to use an option as a viable investment alternative, provided you understand the risks associated.
As an example we will imagine Joe the Trader has determined through technical analysis that the chances of XYZ stock falling in price are fairly high. The stock is currently trading at $ 48 and using Stock Options, his choices are to buy a Put Option and pay the premium for it, or to write a Call Option and receive the premium as income.
He does not think the stock price will rise above $ 50, so he decides to write a Call Option with a strike price of $ 50. Let's say for this he receives $ 5 in premium. The $ 5 goes into Joe's trading account straight away.
What we need to remember here is that there is always another trader on the other side of any transaction who has an opposing view of the market to yours. So for this example we will say that Bob the Trader has determined through his analysis that the chances of XYZ stock rising are fairly high and he decides to buy the XYZ $ 50 Call Option from Joe.
Joe stands to profit from this trade if the Call Option, at expiry, is Out Of The Money (Stock price is below $ 50) and expires worthless. Joe has made a $ 5 profit and is able to write another option. If this were to happen then Bob would lose his $ 5 (or perhaps less if he had closed his position at an earlier stage).
The risk for Joe the Writer in this trade would be if his analysis was wrong and the stock price was trading above $ 50 at expiry. His Call Option would then be exercised and he would be obligated to sell the XYZ shares to Bob for $ 50. As he did not own any XYZ shares in the first place he would have to buy them at market price first to then sell to Bob.
This means Joe's potential loss would be the difference between the stock's current trading price and the $ 50 strike price. However, he would still get to keep his $ 5 in premium, so XYZ would have to trade above $ 55 before Joe would actually realise any loss.
COVERED CALLS - A Covered call is a CALL OPTION written or sold by an investor or trader who does own the underlying stock. Hence the name covered.
You would write a Covered Call if you held a stock for the long term and did not want to sell your holdings, but you wanted to earn money as extra income. Or perhaps you now held a neutral or slightly bullish view on the stock and wanted to realise the profit you had made but earn a little extra profit at the same time.
Let's say that Joe owned the XYZ shares that are trading at $ 48 and while 12 months ago he paid $ 18 for them, they have now started to trend sideways.
Joe has decided to write a Covered Call with a $ 50 strike price and one month to expiry. For this he receives the $ 5 in premium.
There are two possible outcomes:
1) If the share price was trading below $ 50 in one month's time, then the call option would be Out Of The Money and expire worthless.
Joe would get to keep his shares AND the $ 5 premium AND be able to write another covered call for next month.
2) If the share price was trading above $ 50 in one month's time, then the call option would be In The Money and Joe would be exercised. He would have to sell his shares to the option holder for $ 50 each.
HOWEVER. . . he has already made $ 30 in capital growth over the last 12 months on them, PLUS he received $ 5 in premium for the covered call option. So his total realised profit is $ 37!
Covered Call Options are a powerful vehicle for generating an income from shares you own. Just as you Rent out a house you own, and collect the rent as income, you can do exactly the same thing with Shares.