by Tim Leary
Selling covered calls implies a prediction or belief that a particular stock price will remain the same or increase within a finite period of time. The most common length being a 3 month option. Profiting from such a prediction is the motivation why the holder of a stock will consider writing or selling a covered call option. The same, but opposing viewpoint is held by the buyer of that same option.
These functions combine together, and allows two different beliefs about where the future value of the stock is heading, to bet upon. It may seem unclear at first glance, but once the basic’s are understood, then the benefit and the utility behind options emerge, along with the practicality and ability to hedge risk or create it.
Commodities and the trading of them was how it all began. To more readily understand call options and modern stock option trading, a brief history of how they evolved helps to put it into perspective. Buyers of a agricultural product, be it cattle or other livestock, and products such as corn, wheat, soybeans, rice, and many others feared a loss of supply or a rise in price.
Conversely, the seller of the very same commodities hoped to ensure that the fruit of his labor retained it’s value long enough to sell off his harvest and thus avoid falling prices. This simple dynamic required a buyer and seller to agree upon a contract where each hoped his best interest’s would be well served.
The need to attain some type of stability gave rise to the options market as we know it today. Sellers had the same need to somehow buy a type of insurance policy, just as the buyers of the commodities needed to buy some type of insurance.The producers and sellers of the commodities would sell options to lock in customers, and lock in a prices. Selling your planned harvest in advance, backed by legal contracts reduced risk.
Most options are never exercised in the physical sense where the under-lying stock actually changes hands. It most often is strictly a paper transaction. It is impractical to carry the transaction to it end, so most often it is simply traded out from or covered by an opposing position. When a covered call option expires un-exercised, then there is an unhappy buyer and a very happy seller.
A most happy seller, who is also referred to as the writer, is created when the covered call he sold expires out of the money. He now books a profit equal to the premium that he sold the option for. Many sellers of covered calls plan on the option contract expiring un-exercised. There is also an impracticality to actually transfer the shares.The clearing of buyer realized gains, show up in his trading acct digitally, the same as regular stock trading .
Any writer or seller of covered calls is motivated by realizing a gain through the un-exercised expiration of the contract. This is done by virtue of making a profit on a stock he may have owned for an extended period of time.
The are two ways in which a seller of covered calls can hope to profit from his options contract.One way is to plan on selling the options on a stock before he owns it, thus the income from the sale of the contract he wrote reduces his cost of purchasing the stock. The second way is employed by many sellers of covered call options contracts, which is to sell a contract and hope that is will expire. This allows them to keep the income from when they sold the contract. It is another way to make a profit other than earnings, dividends, or a rise in stock price that you sell into.