From Don Fishback
It is very important to note that when you sell an option short, the buyer has all the rights. You, the option seller, have none. The option seller only has obligations.
When you sell a call option short, you are expecting the underlying asset to remain stable or decline in value. Here’s why. When you sell a call, you are not selling short the underlying asset itself – you are selling short a call option. Remember that calls increase in value as the underlying asset increases in price. Calls drop in value as the underlying asset’s price declines. Because we’re selling short a call, we want the value of the call option to drop. Because a call’s value drops when the underlying asset’s price drops, we want the asset to drop in price.
Let’s take a look at an example to see how we can determine our profit and loss potential from the short sale of a call option.
Let’s say that we expect GE shares to drop in September. And the stock market has shown an extremely powerful seasonal tendency to drop during September and October. Because GE shares tend to rise and fall with the market, you want to implement a strategy that makes money when the market falls. You want to sell a call option.
GE is trading at 100 in September. Just as you would when you sell anything, you receive money when you sell an option. In this instance, when you sell a call you receive money, you give the payer something, usually a service or a product. In this instance, you are giving the call option buyer a right. The right you are giving the call buyer is the right to buy GE shares from you at a preset price during a fixed time period. The option you sell is an October 105 call; the price of the call is 3.
The strike price of the option is 105. That means that the option buyer has the right to buy from you GE shares at 105, no matter how high or low the GE shares are. The October date means that the options expire in October (stock options and stock index options expire on the third Friday of the month). As the seller, you have received compensation from the buyer. The compensation you receive (e.g., the price of the option) is called the option premium. The price of the option in September is 3.
Now let’s fast forward to October. Let’s look at what the option will be worth as GE shares fluctuate. Remember, the October call option with a strike price of 105 gives the option buyer the right to buy GE shares from you at a price of 105 before October 18. Therefore, as a seller of a call option, you have the obligation to sell someone GE shares at a price of 105, no matter how high or how low the stock price actually is at the time the option is exercised.
If GE shares are trading at 80 on the New York Stock Exchange, would the option buyer want to exercise their right, call away the stock and pay 105? Of course not. Why would someone want to pay 105 when the open market price of GE is 80? Therefore, when GE shares are at 80, the option has no “exercise” value. In this case, it would be worthless at expiration. You, the option seller, could buy back the option you sold at a price of zero, but that would generate an unnecessary commission. A more likely scenario would be for you, the option seller, and the option buyer to just let the call expire.
What if GE shares were at the strike price – 105? In this case, it really doesn’t matter. The option buyer could either buy the shares in the open market for 105, or exercise the option and buy GE shares from you at 105. If the option buyer exercised his right to buy GE shares from you, you would simply buy the stock in the open market for 105 and sell the shares to the call buyer for 105. You, however, have previously been paid for the option that you sold. In the stock portion of this transaction, you are simply buying at one price (105, the open market price) and then immediately selling the stock at the same price. Since there is no added value to exercising the option, it is essentially worthless.
How about when GE is at 110? At 110, the options have value. The option buyer could exercise his right to “call” away the stock from you and buy it at 105. This forces you to deliver the stock. If the stock is at 110, you would have to buy the stock in the open market at 110 and sell it at 105, the exercise price of the option. In this instance, you lose -5 from the exercise, but you’ve already collected 3, so your net loss is -2. You could also simply offset the transaction by buying back the option. If you bought the option for its exercise value (5), it would show up on your account as a debit (or as a minus).
Here’s a graph of the call short sale’s profit and loss:
The graph above is critical to understanding why the odds are in your favor when you sell an option. Remember, GE shares are trading at a price of 100. Notice that the place in which the profit/loss line drops below zero (the breakeven) is somewhere between 100 and 110. The exact price is 108 – the price of the option when you sold it, plus the strike price. As long as GE shares stays below 108, you make money. If GE shares are above 108 at expiration, the option seller loses. This is the same breakeven as the option buyer, only the option buyer wins if GE goes above 108 and loses if they are below 108 at expiration.