Why would someone want to sell call options?

Question

I'm having trouble understanding why someone would want to sell call options. For example, if the writer of a call option owned the shares and they expected the share price to fall, why wouldn't they just sell their shares instead of selling call options? If I understand it correctly, they benefit only if the share price remains stagnant throughout the duration of the contract? Or would a decrease in price benefit the shareholder/option writer, since they would assume that the share price would eventually bounce back upwards and they would get to keep the premium from selling the option?

On the buyer side, the motivation is more transparent I think. E.g. if the buyer expects the price to rise, buying options allows them to speculate at a cheaper price than buying the actual shares to resell later?

Answer 1

You appear to be thinking of option writers as if they were individuals with small, nondiversified, holdings and a particular view on what the underlying is going to do. This is not the best way to think about them.

Option writers are typically large institutions with large portfolios and that provide services in all sorts of different areas. At the same time as they are writing calls on a particular stock, they are writing puts on it and options on other stocks. They are buying and selling the underlying and all kinds of different derivatives. They are not necessarily writing the option because they are expecting or hoping to benefit from a price move. It's just small part of their business. They write the option if the option price is good enough that they think they are selling it for very slightly more than it's worth.

Asking why an option writer creates a call is like asking why a grocery store keeps buying groceries from their distributors. Don't they know the price of food may not always rise? Sure, but their business is selling the food for slightly more than they pay for it, not speculating on what will happen to its price. Most option writers are doing the same thing, except what they are buying and selling is sets of cash flows and risk.

As a general rule, the business model of option writers is to profit from the few cents of spread or mispricing, not from aggregate changes in the price of the underlying. They should and often do maintain balanced portfolios so their option writing activities don't expose them to a lot of risk.

Also note that there could be lots of reasons for writing options, even if you do have a particular view. For example, perhaps the option writer thinks volatility of the underlying will decrease. Writing a call could be part of an overall strategy that profits from this view.

Answer 2

I do this often with shares that I own - mostly as a learning/experience-building exercise, since I don't own enough individual stocks to make me rich (and don't risk enough to make me broke).

Suppose I own 1,000 shares of X. I don't expect my shares to go down, but I want to be compensated in case they do go down. Sure, I could put in a stop-loss order, but another option is to sell a call above where the stock is now (out-of-the-money).

So I get the premium regardless of what happens. From there three things can happen:

• The stock goes up, but not above the strike - this is the "best case" - I made money by owning the stock, and the option expires worthless, so I keep the stock. I made the premium PLUS the amount that the stock went up.
• The stock goes up past the strike price. I still get the premium, and my stock went up, but I now have to sell it for the strike price.
• The stock goes down. I lose money on the stock, but I earned the premium from the option, which expires worthless

So a covered call essentially lets you give up some upside for some compensation against downward moves. Mathematically it's roughly equivalent to selling a put option - you make a little money (from the premium) if the stock goes up but can lose a lot if the stock plummets.

So you would sell call options if:

• You expect the price to rise slightly (or don't care that your gain is capped if it rises a lot)
• You don't expect the stock to fall significantly
• You think the options are overpriced relative to the risk (this is more of a value play - if you think implied volatility is high and want to sell options to capture some of that value).

Answer 3

I have an example of a trade I made some time ago.

• Stock price - $7.10
• $7.50 call option 16 months out $2.

By entering the position as a covered call, I was out of pocket $5.10, and if the stock traded flat, i.e. closed at the same $7.10 16 months hence, I was up 39% or nearly 30%/yr. As compared to the stock holder, if the stock fell 28%, I'd still break even, vs his loss of 28%. Last, if the stock shot up, I'd get 7.50/5.10 or a 47% return, vs the shareholder who would need a price of $10.44 to reflect that return. Of course, a huge jump in the shares, say to $15, would benefit the option buyer, and I would have left money on the table. But this didn't happen. The stock was at $8 at expiration, and I got my 47% return. The option buyer got 50 cents for his $2 bet.

Note, the $2 option price reflected a very high implied volatility.

Answer 4

"Covered calls", that is where the writer owns the underlying security, aren't the only type of calls one can write. Writing "uncovered calls," wherein one does NOT own the underlying, are a way to profit from a price drop. For example, write the call for a $5 premium, then when the underlying price drops, buy it back for $4, and pocket the $1 profit.

Answer 5

I'll provide another example:

I bought AMD stock in Sept 2018 for an average of $33.03/share and never sold them. Today is 9/19/2019 and the price right now is $30.90/share. so basically 1 year of holding.

In that same time frame the stock has declined ($2.13)/share or about (-6.4%). Had I just bought and held i could be down -6.4%, but I have actually been writing covered calls and selling them close to monthly (sometimes weekly, sometimes longer than a month). In all i have made a +20.5% gain over the past year on that single investment due to rolling the covered calls, or by allowing them to expire worthless, netting myself the profits of the premium i sold them for.

Good luck.

Answer 6

As far as selling a covered call is concerned, reasons could be lowering volatility, liking a steady stream of money, wanting to reduce risk but hold onto the stock for some reason, or thinking the market has overestimated volatility: if the current price is $100, and the market thinks it could vary by $10, and you think it will vary by only $5, then calls will be "overpriced", and you can sell them for more than they're worth.

For uncovered calls, they could be speculation, but it's probably mostly big institutions with large portfolios that can absorb the risk and profit from the premium the market gives for taking on that risk.

Answer 7

If one expects price to drop, selling a covered call is a poor way to protect one's shares. Even if one used ITM options, as share price fell, the delta of the call would decrease and the amount of hedge per point of drop in the underlying would decrease. IOW, the more the stock dropped, the faster your losses would accrue until they approach 1 to 1.

Your premise addresses when one would not want to sell a covered call. However, there are reasons to sell them. Less commonly, one owns shares that have risen and has a somewhat higher target price. Selling a CC at a nearby strike price will generate some premium income while waiting.

What your question ignores is that covered call writing is implemented when one has a neutral to mildly bullish outlook for the stock. While it does provide some modest downside protection, it's primary objective is increased income through stock ownership. The position will outperform the stock if share price drops, goes nowhere or rises a little. A large upside move will be an opportunity loss since you will not participate above the strike price. Writing covered calls will lower the volatility of the portfolio.

Covered calls and their synthetically equivalent short put have asymmetric risk (limited upside with most of the downside risk). An old saying about them is that "Most of the time you eat like a bird and sometimes, you sh*t like an elephant." In good years, you'll lag the market. In bad years, you'll lose but you'll outperform the buy and holder.

Now that I've told you the bad news (g), it's really not that bad. As per CBOE stats:

The CBOE's BXM index represents the returns of a monthly buy-write strategy where the S&P 500 is bought and one at-the-money call is written. Over the past 30 years, the S&P 500 has returned an annual rate of 9.9% with a standard deviation of 15.3%. The BXM has returned 8.9% with a standard deviation of 10.9%

The CBOE's BXMD index represents the returns of a monthly buy-write strategy where the S&P 500 is bought and one call 30% out-of-the-money is written. Over the 30 past years, the S&P 500 has returned an annual rate of 9.9% with a standard deviation of 15.3%. The BXMD has returned 10.7% with a standard deviation of 13.2%

If you have some sort of superior timing and selection skills, you shouldn't monkey with covered calls and short puts. Because of their asymmetric R/R, my preferential strategy for income is vertical and diagonal spreads where there is a floor of protection and unexpected surprises don't hammer me.

Answer 8

For example, if the writer of a call option owned the shares and they expected the share price to fall, why wouldn't they just sell their shares instead of selling call options?

Technically, this is called a "covered call" - it is similar to a plain call, but if you analyze the risk/reward situation it is actually completely different. In fact, many brokers will allow you to make covered calls but not plain calls.

Selling shares is not the same as selling calls, because option value is determined by implied volatility and time value in addition to intrinsinc value (the difference between the strike and current asset price).

• If you sell a call just before a big lawsuit involving the company, you will get a good price because there is a lot of uncertainty. People are willing to gamble on the call because "anything can happen". After the lawsuit, the volatility will implode. The option price will drop because the time where anything can happen have passed - things are more boring now. You can close your position and profit from the change in market expectations, even if the share price didn't move. You cannot do this with stock.
• If you sell a call many months out, it will get a good price because there is a lot of time in which the stock could move in the call buyer's favor. But if the stock ends up not moving, just before expiration the call will have very little value. Because again, the possibilities are no longer there. You can close out and make a profit from the market's expectations being wrong. You cannot do that with stocks.

Generally, if you look at the risk/reward graph of a covered call, you will see that it is not equivalent to selling the stock. There is a small constant gain if the option is never exercised (if the stock doesn't drop enough). This is profit coming from the option premium. You can think of it as a fee that the call buyer pays you, so that you hold the shares for him like a warehouse instead of him having to hold the shares himself. While storage of shares is not an issue in reality, capital requirements certainly are.

If I understand it correctly, they benefit only if the share price remains stagnant throughout the duration of the contract?

Correct. The reason people enter covered calls is that they hold a stock which they think will one day go up (maybe a year later), but in the short term will go sideways (maybe it's July and they think the market will be lukewarm until Christmas earnings come in). So while they are waiting for the bulls to wake up, they sell a covered call to make a little money in the meanwhile without exiting the stock.

Liquidity of options may also be different from the liquidity of stocks. However generally I think stock markets are more liquid than option markets.

Or would a decrease in price benefit the shareholder/option writer, since they would assume that the share price would eventually bounce back upwards and they would get to keep the premium from selling the option?

No, the net gain is constant if the stock drops. The gain in intrinsic value is exactly offset by the loss from shares you hold. However, if you thought the stock would drop, you could just sell it and buy back when it's lower. That would be more profitable than a covered call. But if you think the price will neither drop nor rise, then you cannot make money by buying or selling stocks. You need the covered call.

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The above discusses covered calls which your question describes. However, you might also want to write naked calls. There are two main ways in which you could do this:

• Naked calls are a bearish strategy. If you think a stock will drop, you can profit from it by short selling. But that will require capital and the shares being available to borrow. You will also have to pay a fee for every day you hold them short. But with a naked call, you get paid to hold the position, and the capital requirements may be different.
• There are many strategies like spreads which involve selling a put as part of the composite position. This is also the non-obvious motivation for the buyer - it might be that they are not necessarily expecting the stock to rise, but are establishing some more complex position, part of which is a long call.