Sell A Call

A trader who thinks that a stock price will decrease can sell a call. When a trader sells a call he collects a premium. If the stock price is below the strike price by the expiration date, then the short call expires worthless and the seller keeps the premium. The premium collected is the seller’s profit. Otherwise, if the difference between the stock price and the strike price is greater than the amount collected in premium, then the seller would lose money. Since there is no limit to how high stocks can go, the losses on a trade like this, in theory, are unlimited.

This is also called a naked call. In practice, to sell naked options, a brokerage firm typically requires a seller to deposit funds (margin requirements) sufficient to cover a 2 standard deviation move in the stock price. This trade results in a net credit to the seller, but requires margin to be maintained in the seller’s account until expiration.

Example

Suppose MSFT is trading at $46. A call option with a strike price of $46 expiring in a month is priced at $1. A trader thinks that MSFT will drop below $46 by expiration, so he sells the MSFT 46 call option expiring in 30 days, and receives a $100 credit ($1 x 100 shares). If he’s right, and MSFT drops and stays below $46 by expiration, then he keeps the $100 credit as a profit.

If he’s wrong, and MSFT rallies (goes up) to $50, then the buyer of the option may exercise his right to buy MSFT at the lower price (the strike price of the option), and the difference would be paid by the seller. In this case, the seller would lose:

(Market Price x 100 shares) - (Strike Price x 100 shares)
($50 x 100) - ($46 x 100)
$5,000 - $4,600 = $400

Since the seller collects $100 when the trade is placed, the the net loss is only $300 ($400 - $100).

Profit and Loss (P&L) at Expiration