An equity option is an investment product that provides the option holder the right, but not the obligation, to purchase or sell a specific number of shares of the underlying stock at a set price, known as the strike price, for set period of time. If the holder does not exercise the option within that time period, the option becomes worthless and ceases to exist. An investor may either buy or sell an option to create an opening position. The investor may close her position by making a covering transaction.
Writing Call Options
A call option gives the holder the right, but not the obligation, to purchase a set number of shares of the underlying stock at the strike price until the expiration date. You can sell a call option and receive a premium for agreeing to sell a set number of shares of the underlying stock for a specified price. This transaction is referred to as writing a call option. If you have written a call option you are said to have a short position. If the option expires unexercised you get to keep the premium and the option becomes worthless. If the option is exercised you are obligated to deliver the agreed upon number of shares of stock in exchange for the agreed upon price per share, regardless of the market value of the stock.
You can sell a call option against stock that you currently own. This is referred to as writing covered calls, and it is considered to be a conservative investment procedure. You earn a premium for agreeing to sell your stock for a set price if the option is exercised. If the price of the stock increases and the option is exercised, you get the strike price plus the premium. If the price of the stock drops and the option expires unexercised, you still have the premium to offset the drop in the stock price.
You can sell a call option against stock that you do not own. This is called writing an uncovered call, and it is considered one of the riskiest of all investment strategies because your reward is limited while your risk is unlimited. If the price of the underlying stock increases and the call option is exercised, you will be required to purchase the stock at the current market price and deliver it at the agreed upon strike price.
When you sell a call option, whether covered or uncovered, you create an open position. Options are traded in a double auction market, with a bid and asked price. Although there is a specific buyer and a specific seller for each option, there is no way to buy back the original option that you sold. You can, however, enter into a closing transaction which eliminates your short position. A closing transaction for a short call option position would be to purchase a call option for the same underlying security with the same strike price and expiration date. The two options would cancel each other out, effectively eliminating your position.
Mike Parker is a full-time writer, publisher and independent businessman. His background includes a career as an investments broker with such NYSE member firms as Edward Jones & Company, AG Edwards & Sons and Dean Witter. He helped launch DiscoverCard as one of the company's first merchant sales reps.