Knowing when to close out of a trade is one of the most difficult questions traders have to wrestle with on a weekly basis.
With options contracts, it is no different, and the decision to write, hold, sell or exercise can be confusing – especially because options contracts are impacted by more than just movement in the price of the stock or ETF.
When Should You Use Call Options?
Call options should be written when you believe that the price of the underlying asset will decrease. Call options should be bought, or held, when you anticipate a rally in the underlying asset price – and they should be sold when if you no longer expect the rally.
- Sell your call options or write new contracts when you have a bearish outlook on the underlying asset
- Buy your call options when you are bullish.
There are, however, obligations that can come from writing a call options contract, as opposed to simply buying and holding a call option, which is much less risky. Therefore, it is crucial to understand the requirements of you as an options seller, your options for handling the position, and the appropriate times to act.
Understanding How Call Options Work
This will be review for traders already active in the options markets, but for those just getting started, the following is a brief outline of how call options work.
- Call Options are contracts that allow the buyer to purchase shares of an asset at or before a stated time in the future at a specific price. It is the right, not the obligation to buy the shares of stock at a specific price by a future date.
- Premiums are the prices for options contracts. An options contract represents 100 shares of stock so an options premium will be quoted per share. For example, an option priced at $1.00 would require $100 of capital to purchase.
- Writing a Contract is the term for selling a call options contract. The writer is the seller. As an options seller you will be selling to open the options contract.
- The Strike Price is the contracted price at which the underlying asset is sold.
- In-the-Money means the call options strike price is lower than the stock price.
- At-the-Money means the call options strike price is the same as the stock price.
- Out-of-the-Money means the call options strike price is higher than the stock price.
- Expiration is the date upon which the contract expires. For monthly options, this is the 3rd Friday of the month. Weekly options will expire each Friday.
- Exercising a call option occurs if the holder chooses to buy the underlying asset.
Options can be used to trade many types of underlying assets, the most common categories being individual stocks and Exchange Traded Funds (ETF’s).
Options Are Derivatives
Because options are merely financial instruments and not an asset themselves, they are known as derivatives – meaning their value is dependent on the value of the underlying asset. Therefore, when trading, buying, or selling options contracts, it is essential to remember that your contract is only valuable concerning the price of the underlying asset.
The current value, also known as the intrinsic value of the option, can be calculated by finding the difference between the strike price and the current market price of the underlying asset, in conjunction with the anticipations for the future price of the asset.
Note: Put Options are the right, not the obligation, to sell an asset at a specified price on or before a specified time.
In a lot of ways, they work inversely to call options. For the purpose of this article, they need not be discussed; however, it is essential to understand a Put Option is not the same as selling a Call Option.
Options allow us to place directional trades that reflect our anticipated move in the price of the stock, index, or ETF.
Note: If you already own a call option, you may sell it without incurring the liability of having to sell the asset later. By doing this, you relinquish your rights to buy and remove yourself from the contract.
Trading Call Option
Below is a chart simply outlining the possibilities for options trading, and the scenarios when you should engage in them.
In general, long calls are bullish strategies and have limited losses. Short calls, on the other hand, are for bearish outlooks, and are simpler to make a profit on, but also come with unlimited risk.
Selling a Call Option
First, it is essential to understand that there are two ways to sell a call option, by writing a new contract, or by selling a call option you already own.
Selling A Call Option To Open A Trade
Through your broker, you become the seller of a call option and collect the premium that the option is selling for. You are also responsible for selling the asset at the strike price, should the buyer choose to exercise.
To protect yourself from the risk of unanticipated asset price increases, you may choose to sell call options for underlying assets that you already own; this option call strategy is called a covered call option.
With this method, you can sell a call option against an existing stock position to mitigate the potential losses. That way, should the buyer wish to exercise his contract, you are not obligated to buy the asset at the current price on the market (this strategy is called an uncovered or “naked” call option).
Additionally, depending on the price you originally bought the assets at, you could still make a net gain even if the strike price is lower than the current market price.
When selling, know that the time value of the options contract affects the premium pricing, and is dependent on the remaining length of the contract.
As the expiration date comes closer, the anticipated future price becomes more defined. If there has been ample time for prices to adjust to anticipations, the value of call options decreases and the premiums people are willing to pay for the contracts decrease.
This is known as time decay, and works in your favour as a seller of an option meaning you make money every day from the option losing some of it’s time value.
Selling a Call Option You Already Own – Sell to Close
This is fairly self-explanatory; it is also known as a “Sell to Close.”
You may sell through your brokerage account, and this relieves you of any rights or responsibilities from the contract—more on when to sell later.
Like with other assets (equities, ETF, futures, currencies, etc.), the suggestions for when to hold and when to sell are similar – when your target price for the trade is reached according to your pre-defined trade plan.
A successful investor knows the cues for turns in the market and uses both his technical knowledge and intuition to position himself well. He earns profits off of trades and keeps his portfolio diversified, while still being well managed, to mitigate losses.
When to Sell to Open
Some strategies for when to write a contract are listed below. Some brokerages require certain levels of approval before you can engage in specific trades (or options trading at all).
- Sell Naked Call Option: Selling a naked call is an aggressive way of placing a bearish trade. While it will give you a high probability of success, it also comes with higher risk. We prefer to define our risk with a vertical spread.
- Debit Spread: Buying a long call option with a strike price closer to the stock price and selling an option with a strike price farther out of the money. This will allow you to place a bullish trade with defined risk.
- Credit Spread: Selling a call option with a strike price closer to the current stock price and buying another call option out of the money. This allows you to place a bearish trade but with multiple ways of making money. You will have a lower profit potential but with far less risk when compared to trading a naked option.
- Covered Call: a “safe” way to write contracts because the investor already owns the asset, and therefore is aware of the full loss possible if the contract is exercised. The covered call can allow you to make money over time when you own the shares of stock by selling options against the shares of stock. The premium collected for selling the options can help offset the cost from buying the shares of stock.
General tips for predicting a Bear Market in any asset category are:
- Look at the trend: see how the asset has been performing recently and unless you suspect a positive change in price, go with the trend. For great graphs and daily reports, see the Market Watch website, and consult the Wall Street Journal.
- Watch where the FED is putting its money. Recently, the FED has been buying corporate bonds and exchange traded funds, among exercising other, previously established “tools.” The value of the assets they purchase increases, but closer inspection shows they are often purchased in place of government bailouts, signifying, perhaps, deeper financial troubles or mis-allocation. For more information on the Federal Reserve’s influence on markets, click here.
- For equities, compare the company’s earnings with its market capitalization. This can be a good indicator of a bubble, and then you would need to predict the pop. For a recent example of a company with a high price-to-earnings ratio, see this article about Tesla (TSLA).
- High volatility in an asset’s price can indicate underlying problems in valuation or in the asset itself. These price fluctuations, either stemming from over- or undervaluation or from internal mismanagement, can lead to crashes within an industry, sector, or business.
These signs can help an investor in options to know, or to forecast, when would be an excellent time to earn premiums by selling a call option. We like to focus on a consistent watch list of products over time. This allows us to get to know the products that we trade which can allow us to quickly form an opinion of whether to be bullish, bearish, or neutral on that stock or ETF.
When to Sell to Close
Selling to close is simply selling your right to buy, and one would do this when he suspects the asset to be at- or out-of-the-money at the time of expiry. This would be the case if the buyer, who now holds the call option, changes his outlook from bullish to bearish.
By selling to close, you do not assume any liabilities, as you would with a sell to open. And while you might not recoup all the original premiums paid – by selling before expiry, you at least will recover part of the options premium.
When to Hold a Call Option
While there are reasons to sell your call options, both for profit and to lessen losses, you can also hold your call options – the ideal situation being to keep them and exercise them, or to hold them until their expiry.
When to Let Options Expire
In most cases it will be best to close out of an options position before they expire. We typically like to close the position once they get to within 10 days of expiration. This allows us to avoid the extreme time decay which can cause the options to lose value quickly during the last 10 days of the life of an option.
If the option is out of the money and you are still holding the trade at expiration you can allow the options to expire worthless. The options will expire, and you will be left without a position on that specific product.
When to Exercise Options
Call options allow for nearly unlimited gains and are a great way to generate income if a buyer can correctly anticipate an increase in asset price.
Exercising an option will leave you with a stock position. This will tie up more capital which is why we prefer to close the options before expiration. Closing them out early will allow us to free up the capital for the next trade.
Key Takeaway: The holder of a call option profits when the underlying asset price increases. The option can be closed out any time before it expires allowing profits to be booked.
The Long and Short of It
This article has discussed the reasons to invest in call options, and why and when to hold or sell. One ought to hold his call options when he has bullish anticipation for the value of an asset -or- to sell call options when he has bearish anticipation. The goal of trading options is to anticipate the future price correctly and make a profit from short term directional movement in the price of the underlying stock or ETF.
A final note: Trading options involves risk. We recommend focusing on risk defined options trades that will allow you to make a nice return while limiting the risk. Focus on creating consistent returns over going for the home run trades. Getting a foundation in place is crucial to becoming a successful options trader.
We have included a link below to out free Options 101 Training Course that will help get that foundation in place quickly. Take a look and feel free to contact us with any questions that you might have.