1. Option Basics 1.1 Introduction

An investor who sells a call believes that the underlying stock price will fall and that they will be able to profit from a decline in the stock price by selling calls. An investor who sells a call is obligated to deliver the underlying stock if the buyer decides to exercise the option. When looking to establish a position, the seller must determine:

• Their Maximum Gain
• Their Maximum Loss
• Their Breakeven

Maximum Gain Short Calls

For an investor who has sold uncovered or naked calls, maximum gain is always limited to the amount of the premium they received when they sold the calls.

Maximum Loss Short Calls

An investor who has sold uncovered or naked calls does not own the underlying stock and, as a result, has unlimited risk and the potential for an unlimited loss. The seller of the calls is subject to a loss if the stock price increases. Since there is no limit to how high a stock price may rise, there is no limit to the amount of their loss.

Determining The Breakeven for Short Calls

An investor who has sold calls must determine where the stock price must be at expiration in order for the investor to breakeven on the transaction. An investor who has sold calls has received the premium from the buyer in the hopes that the stock price will fall. If the stock appreciates, the investor may begin to lose money. The stock price may appreciate by the amount of the option premium received and the investor will still breakeven at expiration. To determine an investorâ€™s breakeven point on a short call, use the following formula:

Breakeven = Strike Price + Premium

Example:

An investor has established the following option position: Short 1 XYZ May 30 call at 3.

The Investorâ€™s maximum gain, Maximum loss, and breakeven will be:

Maximum Gain: \$300 (The amount of the premium received) Maximum Loss: Unlimited

Breakeven: \$33 = 30 + 3 (Strike price + premium)

If at expiration XYZ is at exactly \$33 per share and the investor closes out the transaction with a closing purchase or has the option exercised against them, they will breakeven excluding transactions costs.

Notice the relationship between the buyer and the seller:

Because an option is a two-party contract, the buyerâ€™s maximum gain is the sellerâ€™s maximum loss and the buyerâ€™s maximum loss is the sellerâ€™s maximum gain. Both the buyer and the seller will breakeven at the same point.

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