Table of contents
Introduction
Options trading has gained immense popularity since the early 2000s. To navigate this derivative instrument, understanding call writing meaning and its implications is important. This approach in options trading involves selling call options to leverage existing market trends and volatility.
However, what is call writing and how to use it for options trading? Let’s understand it in this article.
Understanding the basics of call writing
So, what is call writing? Call writing, also known as selling call options, is an options trading strategy where a trader sells call options on an underlying security that they already own.
In options trading, a call option gives the buyer the right, but not the obligation, to buy a specific quantity of an underlying asset at a predetermined price (strike price) before the option’s expiration date.
When a trader engages in call writing, they are essentially agreeing to sell a contract of the underlying asset to the option buyer at the agreed-upon strike price if the buyer decides to exercise the option. In return for taking on this obligation, the call writer receives a premium from the option buyer.
There are a few potential reasons why traders might use call writing as a strategy:
- Gain profit: Call writing allows traders to earn premiums from selling call options, providing an additional income stream. This can be particularly attractive in a sideways or slightly bearish market.
- Enhance returns: Traders who already hold a certain stock as an underlying asset may use call writing to enhance their returns. If the contract price remains below the strike price, the call options will expire worthless, and the trader can keep the premium as profit.
- Risk mitigation: Call writing can be used as a risk mitigation strategy. While it doesn’t eliminate risk entirely, it can provide a degree of downside protection through the premium received.
Top call writing strategies for option trading
Now that you have understood the call writing meaning, let’s see some key call writing strategies that can help you while trading options.
1. Covered call writing
Covered Call Writing involves selling call options on an underlying stock you already own to profit.
Doing so gives you a premium from the option buyer, providing a limited profit if the underlying stock rises significantly.
The risk lies in potentially missing out on higher gains if the stock price surges beyond the call’s strike price. Also, remember to have exit strategies for covered call writing.
2. Naked call writing
Naked Call Writing involves selling call options without owning the underlying shares. The objective is to generate income, but it comes with high risk as potential losses are unlimited if the underlying stock price rises significantly.
This strategy is not recommended for inexperienced traders due to its speculative nature and exposure to substantial financial risk.
3. Ratio call writing
In a ratio call writing strategy, you sell more call options than the number of underlying shares you own. The goal is to generate income while allowing some room for the underlying stock’s price to rise. If the underlying stock goes up moderately, you make a profit from the sold options.
However, if the stock sharply rises, your losses are limited. It’s a strategy that combines income generation with potential for modest gains, offering a balance between risk and reward in a bullish market.
4. Buy-write strategy
The strategy involves buying an underlying stock and selling a call option on it simultaneously. The goal is to generate income from selling the call option while potentially reducing the effective purchase price of the stock.
If the underlying stock price rises, you may have to sell the stock at the agreed-upon (strike) price, missing out on some potential gains.
It’s a trade-off between income generation and potential profit limitation in a moderately bullish market.
5. Bull call spread
The bull call spread is a strategy where you expect an underlying stock’s price to rise moderately. To execute this option trading strategy, you buy a call option and simultaneously sell another call option with a higher strike price. This limits your potential losses to the initial trades, providing a capped risk.
However, your profit potential is also limited as it’s the difference between the two strike prices. It’s a conservative strategy suitable for traders anticipating modest stock price increases while managing risk.
What are the risks involved in call writing?
Call writing is often used by profit-oriented traders seeking additional returns from their existing stock holdings. The premium income received can enhance the overall return on trades. However, there are certain risks involved.
Unlimited loss
The spot price (the current market price of the contract) could increase past the strike price, causing the buyer to exercise the option. The writer would then have to sell the shares and deliver the stock. To avoid this, the writer can buy back the call option, but this could cost more than the initial premium.
Early exercise of options
If the buyer exercises the call option before expiration, the seller may be forced to sell the stock or buy back the option at a loss.
Limited profit potential
The maximum profit in call writing is limited to the premium received. If the stock price remains below the strike price at expiration, the call option will expire worthless, and the call writer will keep the premium as profit.
Pin risk
The option could expire slightly in the money just before the market closes on expiration Friday, leaving the writer in a position of uncertainty until the market opens again.
How is call writing different from put writing?
People often find it confusing to understand the difference between call writing and put writing. However, here is a table to help you understand call writing and put writing in detail.
| Feature | Call writing | Put writing |
| Direction | The market perspective is bearish | The market perspective is bullish |
| Objective | Generate income through premium collection | Generate income with the intention to buy the contract |
| Market outlook | Neutral to slightly bearish | Neutral to slightly bullish |
| Risk level | Limited (capped by the underlying stock’s potential rise) | Limited (capped by the underlying stock’s potential fall) |
| Obligation | Obligated to sell the underlying stock at the strike price if exercised | Obligated to buy the underlying stock at the strike price if exercised |
| Profit potential | Limited to the premium received | Limited to the premium received |
| Break-even point | Strike Price + Premium Received | Strike Price – Premium Received |
| Market condition | Used in a sideways or slightly bearish market | Used in a sideways or slightly bullish market |
| Volatility Impact | Benefits from low to moderate volatility | Benefits from low to moderate volatility |
Conclusion
Call writing is a strategic yet nuanced approach to trading. By selling call options, traders can gain profit but must be aware of potential risks, such as limited upside and the obligation to sell at a predetermined price. Balancing rewards with potential drawbacks is key to a successful strategy in call writing. For further insights, subscribe to StockGro.
FAQs
Call writing is a strategy that includes selling call options. In this options trading strategy, you are supposed to sell call options on an underlying security that you already own.
You can use call writing to earn premiums from selling call options, which provides an additional income stream. You can also use this strategy to hedge your existing trading position in an underlying asset by selling call options of that particular asset.
In call writing, you sell call options, while for put writing, you buy put options. While call writing is used for bearish market conditions, put writing is used in bullish conditions. Both strategies have limited profit potential tied to the premium amount.
Call writing is often used by profit-oriented traders seeking additional returns from their existing stock holdings. However, here if the market moves in the opposite direction and if enough risk mitigation measures are not in place, the loss can be unlimited. Thus, you need to research well and have measures in place to limit your losses.
Some of the popular call writing strategies are covered call writing, naked call writing, buy-write, bull call spread, and ratio call writing.
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