during this two-month period—not to short the stock. Because equity
options are American exercise and can be exercised/assigned any time from
the moment the call is sold until expiration, a short stock position cannot
always be avoided. If assigned, the short stock position will extend Sam’s
period of risk—because stock doesn’t expire. Here, he will pay one
commission shorting the stock when assignment occurs and one more when
he buys back the unwanted position. Many traders choose to close the naked
call position before expiration rather than risk assignment.
It is important to understand the fundamental difference between buying
calls and selling calls. Buying a call option offers limited risk and unlimited
reward. Selling a naked call option, however, has limited reward—the call
premium—and unlimited risk. This naked call position is not so much
bearish as not bullish . If Sam thought the stock was going to zero, he
would have chosen a different strategy.
Now consider a covered call example:
Buy 100 shares TGT at $49.42
Sell 1 TGT October 50 call at 1.45
Unlimited and risk are two words that don’t sit well together with many
traders. For that reason, traders often prefer to sell calls as part of a spread.
But since spreads are strategies that involve multiple components, they have
different risk characteristics from an outright option. Perhaps the most
commonly used call-selling spread strategy is the covered call (sometimes
called a covered write or a buy-write ). While selling a call naked is a way
to take advantage of a “not bullish” forecast, the covered call achieves a
different set of objectives.
After studying Target Corporation, another trader, Isabel, has a neutral to
slightly bullish forecast. With Target at $49.42, she believes the stock will
be range-bound between $47 and $51.50 over the next two months, ending
with October expiration. Isabel buys 100 shares of Target at $49.42 and
sells 1 TGT October 50 call at 1.45. The implications for the covered-call
strategy are twofold: Isabel must be content to own the stock at current
levels, and—since she sold the right to buy the stock at $50, that is, a 50
call, to another party—she must be willing to sell the stock if the price rises
to or through $50 per share. Exhibit 1.4 shows how this covered call
performs if it is held until the call expires.