When you are bearish on the market and feel confident that it won't rise in the short term, you might consider selling calls to generate additional income. When you hold the assets for which you are selling the calls, then they are covered calls and there is limited risk. If you do not hold the assets, you are selling naked calls and your risk is unlimited, although your profits are limited. You must be careful when selling naked calls.
With this strategy, you are selling someone the right to buy an asset at a fixed price (the strike price), on or before the expiration date of the option. It is a bearish strategy or bearish directional strategy. You are a call writer (selling the call).
This strategy has some nice benefits.
You receive a premium for selling someone the right to purchase an asset at a particular price that you feel it will stay below. If the asset price is below the strike price at expiration, then the calls that you sold are not exercised and the premium that you collected provides additional income for you, increasing your rate-of-return. If you are writing calls
or out-of-the-money calls, the asset may continually increase in value, yet the options may never get exercised, allowing you to do this over and over again. This generates continuous income for you, increasing your portfolio and generating cash flow for other investments.
If the calls that you sold do get exercised, then you are obligated to sell the asset at the exercise price. But you essentially sell the asset at a premium from the asset price that existed when you sold the calls, because you collected the option premium. You have already agreed that you would like to sell the asset at the exercise price and the price is augmented by the option premium that you collected.
Since you are the seller of the option, the time decay of the option works in your favor. The time-value portion of the call premium constantly declines with time, going to zero on the expiration date. The rate of decay is predictable and is easily calculated by options analysis programs such as Option-Aid. As the expiration date approaches, the rate of decay increases. For this reason, it is often better to sell calls with one month or less until expiration. After they expire, you can sell calls on the next month out and collect another premium if you still have the same view of the market at that time.
It is also important to cover risks and caveats of this strategy.
If the asset price rockets skyward and stays above the strike price at expiration, then the option will probably be exercised and you will be obligated to sell the asset at the agreed-on strike price or cover the option, incurring a loss. If you sold naked calls, your risk is unlimited.
It is important to analyze your expectations for the underlying asset before selling the call. If you expect the asset price to remain stable, you can write the call approximately at-the-money and collect a larger premium. If you sell an in-the-money call, the premium you collect will be even larger, but you run a greater risk of the option being exercised.
