Selling Call Options Against a Portfolio
I remember lecturing in Chicago some years ago, and after this talk, during a question-and-answer period, one of my audience said, "I have bought options, but I never knew I could sell them." Well, for every tradewhether in options or clothing or real estatethere must be both a buyer and a seller. It is usually very interesting to my audiences to learn where options come from, who makes them, and why. I'll try to explain the selling of options, the advantages to the seller, the disadvantages, and the pitfalls, for I said at the outset that I would show the good side and the bad.
Options are sold by individuals, funds, trusts and insurance companies, andas I like to sayby anyone who has what I call "a continuous portfolio of common stocks." One who sells options must be percentage-mindedthe man who buys a stock at 50 and expects to get 150 for it is not a prospective seller of options, but the man who is satisfied to take a premium of, say, $300 and for that give a Call on his stock for 90 days, and then repeat that procedure over and over again, is percentage-minded and could do well. It is my contention that the selling of options against a portfolio is no more speculative than is the owning of such common stocks.
Consider, if you will, a man (or an institution) who owns 1,000 shares of a stock selling at 50. He sells a Call, good for 90 days, at 50, for which he receives $300 per 100 share Call. This $300 he receives as soon as he sells the option. Let's see what happens if the stock goes up, and also what happens if the stock goes down.
If the stock goes down and is below the Call price when the option expires, the Call will not be exercised. The seller of the Call will still have his stock and will have profited by the $300 which he received for the Option. If he can sell such an option four times a year (and there are four 90-day periods in a year), he will make $1,200 in premiums, or almost 25 per cent per annum on the $5,000 investment.
Let's look at the other side: the stock advances and the stock is selling above the Call price when, or before, the option expires. The stock is "Called" and the seller of the option must deliver stock at 50, less any dividends. He then has:
| ||Sold 100 shares at 50 ||$5,000|
| ||Received $300 for Call ||300|
| ||Total Received ||$5,300 |
I am sure that after Mr. Trader has had his stock Called and Has $5,300 to re-invest, he can think of another stock which he would be willing to buy. Let's say that this stock is also selling around 50, and he buys 100 shares and then sells a Call against it. The stock will either go up or down. If it goes up, he has his $300 premium again for the second Call and he loses his stock. If it goes down, the Call won't be exercised. He has the $300 premium and is at liberty to sell a Call again on the same stock if he cares to do so.
It is just as simple as that and quite automatic. One shouldn't sell a Call at one time and for one expiration date on all of his stock, but should try to sell a Call on part today, at today's price, and a Call on part of his holdings at a later date at the current market price in an attempt to have staggered prices and options expiring on different dates, like this:
| ||Sold call 200 at 50, expiring June 20 Premium ||$600|
| ||Sold call 200 at 52 expiring July 7 Premium ||600|
| ||Sold call 300 at 54 expiring July 18 Premium ||900|
I believe that there are two pitfalls to avoid in the selling of options: (1) Never sell a Call option unless you own the stock, and (2) Never sell a Put option without the wherewithal to pay for the stock in case it is Put to you. Otherwise, the risk in selling options is no greater, in my opinion arrived at through years of experiencethan the risk in owning like common stocks. For instance, if one had sold Calls freely in the beginning of 1958 without owning the stocks, he could have been Called for stock at 50 when it was selling at 80. If one had sold Puts in the summer of 1957 without having sufficient cash to pay for the stock when it was Put to him, he might have had stock Put to him at 50 when it was selling at 30. The return to be had by selling options almost on an investment basis is interesting enough without looking for additional income and additional grief by trying to gain additional premiums.
Before going into the selling of Put options, Straddles, Spreads, Strips and Strapsa word about margins. The New York Stock Exchange has set minimum initial margin requirements for the sale of options by customers of its member firms. However, these member firms may increase these requirements according to house policy. The minimum initial margin for the selling of a Put option is 25 per cent of the Put option price, unless the account is "short" the stock, which is already adequately margined. The minimum initial margin requirement for the sale of a Call option is 30 per cent of the stock on which the Call is written, unless the Call is written on stock already "long," in which case the "long" stock is already adequately margined. The minimum initial margin requirement for the sale of a combination Put and Call (Spread or Straddle) where there is no stock position, is the larger of the two requirements for the separate Put or Call, or 30 per cent.
It must be emphasized that these are minimum initial requirements and that they may be increased by the member firm where the customer has his account but they cannot be below these initial requirements as fixed by the rules of the New York Stock Exchange. Before attempting to sell options, arrangements should be made with your stock-exchange broker for the guarantee of such contracts. Your stock-exchange broker will also advise you what the margin requirements are.
When an option is exercised, however, thereby creating a stock position, the position must be fully margined according to stock-exchange requirements.