Call Writing Meaning

Call writing is a strategy in which an investor sells a call option, promising to sell the underlying asset at a set price before the option expires. It’s mainly used to earn income but can be risky if the asset’s price goes up too much.

What Is Call Writing?

Call writing is the act of selling a call option, which gives the buyer the right to buy an asset at a specific price within a certain time. The seller collects a premium for this option. If the price doesn’t rise above the strike price, the seller keeps the premium.

In call writing, the investor sells a call option on an asset they own or are willing to sell. The goal is to earn the premium from the option buyer. If the market price stays below the strike price, the option expires worthless. However, if the price rises, the seller must deliver the asset at the agreed price. This strategy works well when the investor expects limited price movement in the asset.

Call Writing Example

An example of call writing is when an investor sells a call option, giving the buyer the right to buy an asset at a specific price within a set time. The seller earns a premium for this, and if the price doesn’t rise above the strike price, the seller keeps the premium.

Suppose you own 100 shares of a company worth ₹1,200 each, and you sell a call option with a strike price of ₹1,300, receiving a ₹40 premium per share. In this case, you earn ₹4,000 from selling the call option (100 shares × ₹40 premium). If the stock price stays below ₹1,300, the option expires worthless, and you keep the entire ₹4,000 premium as profit. However, if the stock price rises above ₹1,300, the buyer of the option may choose to exercise it. 

In this situation, you must sell your shares at ₹1,300 each, regardless of how high the market price has gone. While you still make a profit from the ₹1,300 sale price and the ₹40 premium, your profit is capped because you can’t sell above ₹1,300, even if the stock price reaches ₹1,500 or more. This limits your potential upside but provides you with immediate income from the premium.

Objective of Call Writing

The main objective of call writing is to generate income by selling call options. It allows the investor to earn a premium upfront while taking on the obligation to sell the underlying asset if the option is exercised by the buyer.

• Generate Income: The primary objective of call writing is to earn a premium by selling a call option. This premium provides immediate income for the investor, regardless of whether the option is exercised. It is particularly useful in a sideways or stable market where price movement is expected to remain limited.
• Benefit from Price Swings: Call writing works best when the investor expects minimal price movement in the underlying asset. If the asset price remains flat or only slightly increases, the option expires worthless, and the seller keeps the entire premium, maximizing profit without taking on much risk.
• Risk Management: Call writing can be a way for investors to manage risk, especially for those holding underlying assets like stocks. By selling call options on these assets, they receive income, which can offset potential losses if the asset’s price falls. However, this strategy can limit the upside potential.
• Create Additional Revenue in Long Positions: For investors holding long positions in stocks, call writing offers a strategy to boost returns. By selling call options against the stocks they already own, they collect premiums in addition to any dividends or potential capital gains, creating an extra source of revenue.
• Reduce Volatility Impact: In volatile markets, call writing can help eliminate the impact of large price swings. The premium income from selling calls acts as a cushion against declines in the underlying asset’s price, providing some level of financial protection while still being exposed to potential price movement.

Types Of Call Writing In Stock Market

The main types of call writing in the stock market are covered call writing and naked call writing. Covered calls involve selling options on assets the investor already owns, on the other hand, naked calls are sold without owning the underlying asset.

• Covered Call Writing: In covered call writing, the investor already owns the underlying asset (such as stocks). They sell a call option against these holdings, earning a premium. If the option is exercised, the investor sells the asset at the strike price. This strategy limits potential gains but provides steady income from premiums, especially in a stable or slightly rising market.
• Naked Call Writing: Naked call writing involves selling call options without owning the underlying asset. This strategy carries significant risk because, if the option is exercised, the seller must purchase the asset at market price and sell it at the strike price. Naked calls can generate high premiums but expose the investor to potentially unlimited losses if the asset price rises sharply.

Benefits Of Call Writing

The main benefit of call writing is that it allows an investor to earn additional income through premiums while holding onto their assets. This strategy is ideal in stable or slightly rising markets and offers a way to generate returns without selling the underlying asset.

• Generate Extra Income: One of the key benefits of call writing is the ability to generate extra income by selling call options on assets the investor already owns. The premium received from the option buyer adds to the investor’s overall return, providing a consistent revenue stream, especially in stagnant markets.
• Risk Management: Call writing can help manage risk by offsetting potential losses in the underlying asset. The premium earned acts as a cushion, reducing the impact of a price decline. This can be beneficial for investors looking for downside protection without having to sell their assets.
• Better Portfolio Returns: For investors with a long-term holding strategy, call writing offers a way to improve portfolio returns. By selling call options on stocks or assets they already own, investors can earn income on assets that may otherwise be underperforming or not actively contributing to their portfolio growth.
• Lower Volatility Exposure: In volatile markets, call writing can help reduce exposure to sudden price movements. By selling call options, investors can earn premiums even if the market is fluctuating. It can provide some protection against market swings while still being exposed to potential upside if the stock price increases moderately.
• Limited Risk in Covered Call Writing: In covered call writing, the investor’s risk is limited to the potential opportunity cost of missing out on further gains. Since they already own the underlying asset, they are only obligated to sell it at the strike price, which helps manage risk while earning income.

Disadvantages Of Call Writing

The main disadvantage of call writing is that it limits potential profits while exposing the call writer to significant risk. If the asset’s price rises sharply, the call writer may face losses or miss out on substantial gains beyond the option’s strike price.

• Limited Profit Potential: Call writing caps the investor’s profits at the strike price plus the premium received. If the asset’s price rises significantly beyond the strike price, the writer cannot benefit from this increase. This limitation makes it less attractive in bullish markets.
• Risk of unpredictable Losses in Naked Call Writing: In naked call writing, the writer does not own the underlying asset. If the asset’s price rises sharply, the writer must purchase it at a higher market price to fulfill the contract. This creates the possibility of unpredictable losses, which is a major risk.
• Market Timing Challenges: Call writing requires accurate predictions of price movement and timing. If the writer misjudges the market, the strategy can result in suboptimal outcomes, such as premature losses or missing out on favorable price trends. This adds complexity and risk to the process.
• Obligation to Sell Assets: In covered call writing, the call writer must sell the underlying asset if the buyer exercises the option. This could force the writer to part with assets they intended to hold long-term, disrupting investment goals or resulting in tax implications.

Factors Influencing Call Writing Options

The primary factor influencing call writing options is the price movement of the underlying asset. Other critical factors include market volatility, time to expiration, and interest rates, all of which determine the premium received and the overall risk and profitability of the strategy.

• Underlying Asset Price Movement: The price of the underlying asset directly impacts the outcome of call writing. A stable or slightly rising price benefits the writer, as the option may expire worthless. However, sharp price increases can lead to potential losses or limited gains for the writer.
• Market Volatility: High market volatility increases the premium of call options, offering greater income for the writer. However, it also raises the risk of significant price swings, which could lead to the option being exercised. Lower volatility reduces premiums but offers more predictable outcomes.
• Time to Expiration: The length of time until the option expires plays a significant role in determining the premium. Longer expiration periods usually result in higher premiums, but they also carry greater risk, as the underlying asset has more time to experience significant price changes.
• Interest Rates: Changes in interest rates can indirectly affect call writing by influencing the value of the underlying asset and option pricing. Higher rates may lead to reduced stock prices, impacting the attractiveness of call writing strategies and altering expected returns for the writer.
• Dividend Announcements: If the underlying asset is a dividend-paying stock, upcoming dividend announcements can influence call writing decisions. A higher dividend yield might attract buyers, impacting option premiums. Writers must consider dividend payouts as they can affect the asset’s price and option demand.

Call Writing Strategy

The primary call writing strategy focuses on selling call options to earn income while controlling risk exposure. This method is used to collect premiums in relatively stable markets, boost overall portfolio income, or protect existing investments from price declines without selling the underlying asset.

• Covered Call Strategy: This strategy involves selling call options on assets the writer already owns. It generates income through premiums while allowing the writer to retain ownership of the asset. If the option is exercised, the asset is sold at the strike price, capping potential profits but reducing risk.
• Naked Call Strategy: In this strategy, the writer sells call options without owning the underlying asset. It offers higher premium potential but carries significant risk if the asset price rises sharply. Writers use this in markets where they predict limited price movement or to capitalize on overvalued options.
• Buy-Write Strategy: This approach combines buying the underlying asset and selling call options on it simultaneously. It aims to generate income from the premium while holding the asset. This strategy works well for investors seeking regular income from stagnant or moderately rising markets.
• Rolling a Call Option: When an existing call option approaches expiration, writers may roll it forward by buying back the current option and selling another one with a later expiration date. This extends the position, allowing the writer to earn additional premiums while adjusting to market changes.
• Out-of-the-Money (OTM) Call Writing: Writers sell call options with a strike price above the current market price of the asset. This strategy reduces the likelihood of the option being exercised, allowing the writer to retain the asset and keep the premium while profiting from gradual price increases.

Call Writing Vs Call Buying

The key difference between call writing vs call buying lies in purpose and risk. Call writing earns a premium with limited profit potential, offering steady income. In contrast, call buying profits from price increases provide unlimited gains but require an upfront premium payment.

Call Writing Meaning – FAQs

We hope that you are clear about the topic. But there is more to learn and explore when it comes to the stock market, commodity and hence we bring you the important topics and areas that you should know: