Keeping Things Straight
Most people have trouble keeping the concept of call buyer and seller straight, so this chapter with lots of pictures should help.
For this example, you’ll be the call seller.
The Setup
So you have a funny hat, and 100 shares of VTI (100 shares is one “lot”, and all call contracts are sold by the lot). The other person is an investor looking to speculate, and wants to pay you for the right to buy those shares at a certain price (this price is the strike price of our sample contract).
Selling The Call
That investor person gives you some money, and they buy a “call” contract from you for the right to buy those shares. They are the call buyer.1
You sell the investor person the “call” contract to buy shares from you for a set price.2 You get the cash (the call premium), and they now own the contract (the call option) you sold them. You are the call seller, since you sold them the call.
If The Price of The Stock Goes Up
If the price of the stock goes up the call buyer is happy. The person holding the call has a right to appreciation above the strike price. You still have the premium and appreciation up to the strike price, but you would miss out on any gain above that, as it would go to the call holder. Additionally, you may have to sell shares if they remain above the strike until expiration and you don’t buy the contract back.
If the Price of the Underlying Stock Stays The Same, Or Declines a Little
If the price of the stock stays the same or only goes up or down a bit, the call buyer is sad because his call isn’t worth much (if anything) when the contract expires. You (the call buyer) are happy because you made the call premium that you wouldn’t have made otherwise. You’d also be happy if the stock only went up to your strike price or a little bit past it, because the call premium might be worth as much as the rise in price, so you didn’t “miss out” on much of the price appreciation.
If The Stock Tanks
If the price of the stock dropped a lot, you’d both be sad. The call buyer’s call expires worthless, and you lost money on your shares, but not as much as you would have lost if you hadn’t sold the call— the premium you received mitigates the loss on shares.
Buying Back The Call You Sold
And if the call contract isn’t worth much anymore (because the share price stayed below the strike price as expiration approached), you can buy back the call option for less money than you sold it for. This buying back is called a Buy-To-Close, or BTC. Once you Buy-To- Close the contract, you are no longer obligated to sell him your shares anymore(( The contract is closed, done, kaput, etc. )), and you get to keep whatever premium is left over after you paid to buy the call back.
Notice in the picture that only one of the four symbolic dollars was required to buy the call contract back and relieve the wizard of his obligation to sell shares. This was done intentionally to illustrate the call’s decline in value relative to when it was sold, due to the underlying shares never reaching and/or surpassing the strike price.
Next- Article 7: Reading Options Chains
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- Who is this call buyer? Some unknown person who thinks they can make money by buying the call, randomly assigned by your brokerage. When you sell and buy back calls, it may not even be from the same person; your brokerage handles the transaction and it is anonymous. [↩]
- Higher than what the shares are trading at today, if you are doing portfolio overwriting. This is an OTM (Out of The Money) call. We cover the details of what makes a call OTM later. [↩]