Up to now the discussion has centered around buying options which gives the buyer the right to buy or sell a stock at a given price.  This discussion is aimed at buying, or as it is sometimes called, writing an option.  When you write an option you are paid money to buy or sell a stock at a particular price.  If you had written a September Call option on Microsoft with a Strike Price of 27 on August 22 you would have been paid 1.29 per share or $129 for a typical contract of 100 shares.  At that time the stock was selling at 27.84 and your option would lead to a gain of .45 per share or $45 (27 strike price plus 1.29 premium or 28.29).  Unfortunately, the seller of the option has the obligation to sell the stock if the buyer of the option decides to exercise the option.  The writer does not have the right to sell the stock whenever he or she wants.  The buyer of the option, on the other hand, can exercise that option whenever, but would do so only if the price of the stock is at or above the strike price.  That is, one would not exercise a Call option to buy the stock at 30 if the current price of the stock is 25.

Why would anyone want to write a Call?  In very simple terms: to make money.  If you wrote an October 28 Call on Microsoft you would be paid 1.12 which you would keep if the stock closed below 28 on expiration day.  If the stock closed above 28 you would be forced to sell it at 28.  If you did not own the stock, you would have to buy it at the market to sell it at the 28 strike price.  This is called writing a naked Call and is one of the riskiest option strategies you can make.  Your loss is unlimited since the stock could rise indefinitely and your only compensation is the $128 premium.

In contrast to the naked Call is the Covered Call one of the most common option strategies.  In this strategy you own 100 shares of stock for every Call contract you sell.  One reason for using this strategy is to increase the sale price of a stock you intend to sell.  Suppose you own 100 shares of Google that has a current price of 490 and you want to sell if by no later than December 31.  You could sell it today for $49,000.  As an alternative, you could sell a December 480 Call for about 50.  At expiration, if the stock is at 480 or above, it will be called away and you will be paid $48,000 for the stock which will be added to the $5000 premium you were paid for writing the Call for a total of $53,000 or $4,000 more than just selling the stock outright.  What are the risks?  The stock could jump to 600 and you would miss out on that gain.  But if you were selling the stock anyway, you would have missed it anyway.  Another risk is the stock decreases in value below 480 and is not called away at expiration.  You would then have to sell it at the current market price.  However, you still have the $5,000 premium and the stock would have to fall below 450 before you suffered a loss. 

The second strategy using a Covered Call is based on the opposite premise: you want to keep the stock and use it to generate income. In this case you do not want the stock to reach the Strike Price at expiration so that the option will expire worthless and you will keep the premium.  The risks are the same but the implications are different.  If the stock decreases in value, your net worth also decreases, but this is partially offset by the premium you received by writing the Call.  Whether or not you wrote the option, you would have sustained the same unrealized loss.   If the stock rises above the strike price, it will be called away and you will no longer own it.  You will have sold it at the strike price plus the premium and your total gain would depend on the price at which you bought the stock.

In future articles we will see that the option buyer or writer does not have to sit passively and wait for expiration day, but can take action before then to exercise the rights of the buyer or avoid the obligations of the writer.

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