9-05 Writing Covered/Naked Calls

chapter9-5aWe noted earlier that 35% of option buyers lose money and that 65% of option sellers make money. Option trading comes down to the turtle and the hare story. Option buyers are the rabbits that are generally looking for a quick move in stock prices, and the option sellers/writers are the turtles that are looking to make a few dollars each day.

In the YHOO examples above we said that if YHOO is at $27 a share and the October $30 call is at $0.25, then not many option traders expect YHOO to climb above $30 a share between now and the 3rd Friday in October. If today was October 1st and you owned 100 shares of YHOO, would you like to receive $25 to give someone the right to call the stock away from you at $30? Maybe, maybe not.

But if that October $30 call was currently trading at $2 and you could get $200 for giving someone the right to call you stock away at $30, wouldn’t you take that? Isn’t it very unlikely that with only a few weeks left to expiration that YHOO would climb $3 and your YHOO stocks would be called away? In effect, you would be selling your shares for $32 (the $30 strike price The price at which the option contract can be executed. plus the $2 option price).

Option sellers write covered calls Writing/selling a call option on a stock that you currently own. as a way to add income to their trading accounts by receiving these little premiums each month, hoping that the stock doesn’t move higher than the strike price before expiration. If the October calls expire worthless on the 3rd Friday in October, then they immediately turn around and sell/write the November calls.

When you own the underlying stock and write the call, it is called writing a “covered” call. This is considered a relatively safe trading strategy. If you do not own the underlying stock, then it is called writing a “naked” call. This is considered a very risky strategy, so don’t try this at home!

Mark's Tip

The reason that option sellers/writers usually win on their trades is they have one very important factor on their side that the option buyer has working against them—TIME. If today is October 1st and YHOO is at $27 and we write the YHOO $30 call to receive $2.00, we have 21 days to hope that YHOO stays below $30. Each day that goes by and YHOO stays below $30, it becomes less and less likely that YHOO will pop over $30. so the option price starts decreasing. On October 10th, if YHOO is still at $27 then the October $30 call would probably be trading at $1.10 or so. This is called the “time decay The reduction in an option price that occurs over time due to the reduced chance of a big price movement in the underlying stock.” of options in that each day that goes by the odds of a price movement become less and less. This is the turtle winning the race!