Now let’s see what happens when we add call options to the mix. First let me quickly cover the nitty gritty of how options work:
- An option is a financial instrument that grants you the right, but not the obligation, to either buy or sell 100 shares of a financial asset (such as Apple stock) at a predetermined strike price.
- Options have expirations. That means that after the expiration date, they cease to exist, poof (for example, our Apple option expires in about 2 and a half months on 11/15/2019).
- But at any time prior to expiration, if you own the call option you can choose to pay the strike price to buy the shares of the underlying stock. Generally, you only want to do this if the stock price is higher than the strike price (if it is, you are effectively buying the stock at a discounted price).
- If you work in tech, you probably already own some really long duration options on your employer’s equity. Lucky you!
Let’s look at what buying and holding a call option looks like on our payoff diagram (below). Notice that there is now a kink in our blue payoff line. The way the line flattens out at the strike price as we move left on the diagram means that our losses are capped at the premium (the price we paid for our call option). This is an attractive aspect of investing in options — the knowledge that regardless of what happens, our losses are capped at the premium. The other aspect of call options that investors love is the unlimited upside. Notice that as we move right on the diagram our blue payoff line goes up in the same way as it would if we owned the underlying stock. This means that by paying just the premium, we end up getting the same economic exposure that we would have if we had bought the underlying stock outright (when the stock price is greater than the strike price).
On the other hand, one disadvantage of owning call options is that unlike with buying stocks, if the underlying stock price doesn’t move at all, you still take a loss since you are out your premium (also call options don’t pay dividends even if the underlying stocks do).
Additionally, there are also the added dimensions of time to expiration and the fact that the rate at which your option’s price changes is itself not constant and a function of many things (for example if our strike price is much higher than the current market price and the option is close to expiring, then even a large increase in the price of the underlying stock may not change the value of our option much) — these factors make options investing much more complicated than it appears at first glance. If you plan to jump into options investing whole hog, you must understand how all of these additional factors work before doing so.
If you sold a call option instead, which is what we want to do in our example, everything works in reverse. In this case, we have sold to someone (for a price) the right to make us buy 100 shares of the underlying stock at the strike price. Since everything is in reverse, we are now forced to take a loss if the stock price moves above the strike price on the call option we sold — in this case, the person who bought the option from us would force us to sell him or her 100 shares of the underlying stock for a price lower than the market price of the stock (so we are forced to sell at a discount).
The graph to the left shows the payoff diagram for writing (a.k.a. selling) a call option. It’s pretty much exactly the reverse of the previous one. Notice that the blue payoff line now starts above $0 for low stock prices all the way up to our strike price. This means that as long as the market price of the underlying stock is below the strike price of our option when it expires, we get to keep all of the option premium (the money we got for selling the option). Also observe that the premium is the maximum amount we can gain from selling a call.
Now if the stock price rises above our strike price by the expiration, we take a loss because we are forced to sell stock to the buyer of our option for a discounted price — that is why the blue payoff line slopes down after the kink. Notice that the potential loss is uncapped — if the price of the stock keeps going up then our losses would keep going up along with it. So selling call options provides limited upside while exposing us to unlimited downside (scary!).
Yes it is scary, but I am definitely not recommending that you write naked calls (selling calls without first owning the underlying stock, and yes it really is called that) as doing so on the wrong stock can be devastating. For example, imagine if you sold one 11/15/2019 (the expiration) Amazon call option at a strike price of $1,940. That’s about 10% above the current market price. For selling the call, you would receive a cool $3,300. Pretty nice right? But if Amazon returned to its 52 week high of $2,050, you would be forced to sell 100 shares of Amazon at $1,940. And since you sold a naked call, you would need to buy 100 shares at $2,050 and then immediately sell them for $1,940 — a loss of $11,000. So your total P&L (profit and loss) is:
- Received premium of $3,300 for writing the option.
- Took a loss of $11,000.
- For a net loss of $7,700… ouch!
We don’t want to be exposed to that kind of risk so writing naked calls are out of the question. But writing covered calls (selling call options when you already own the stock) in a richly valued stock market can be a risk reducing and potentially attractive trade for risk averse investors. Let’s see how in the next section.