Selling Call Options
One of the most difficult decisions an investor has to make is when to sell. Often an investor will choose a price at which they believe the shares are sufficiently overpriced and enter a limit order to sell the shares. This is a very common approach, but what if you could get paid for waiting to sell? By selling call options, you can make a tidy profit while waiting for the price of your stock to rise.
What Is A Call Option?
A call option is a contract between the buyer and the seller of the option. The buyer pays the seller a premium for the right, but not the obligation, to buy 100 shares of the underlying stock at the strike price on or before the expiration date. The seller of the option is obligated to sell these shares if the option is exercised by the buyer.
So how is this related to selling stock? Let's imagine Bob owns 500 shares of XYZ which he bought a few years ago for $10 per share. The stock currently trades for $18 per share and Bob has determined that he wants to sell his shares for no less than $20 per share, 11.11% above the current market price. After looking at the options chain Bob sees that he can sell a call option with a strike price of $20 and an expiration date three months in the future and receive a premium of $0.20 per share. Bob sells 5 call options contracts and collects a premium of $100.
There are two possible outcomes for Bob:
- The market price never reaches $20 per share and the call options expire worthless. Bob does not have to sell his shares and is free to sell another set of call options.
- The market price rises above the strike price and Bob is forced to sell his 500 shares of XYZ for $20 per share, which is less than the current market price.
If scenario 1 plays out Bob realizes a 1% return over 3 months, or a 4% annualized return, from the premium received (percentages based on the strike price). You can view this as a dividend enhancement if XYZ pays a dividend, as it has the effect of increasing the effective dividend yield. If scenario 2 plays out Bob is forced to sell his shares, which he wanted to do anyways, and the premium acts to raise the price per share realized to $20.20.