What Is Call Writing?

Call writing is a common strategy in option trading. It involves selling call options, which gives the buyer the right (but not the obligation) to buy an asset at a set price. Investors use this strategy to earn extra income or protect their portfolios. While call writing can be profitable, it also carries risks, so it’s important to understand how it works before using it.

Components of Call Writing

The call writing in options trading can also be described as selling a call option, which allows the buyer the right, but not the obligation, to purchase the underlying asset at a prefixed price before the expiry date. Key components include:

1. Underlying Asset: The underlying asset refers to the stock or index or the commodity that serves as the option’s basis.
2. Strike Price: Strikers agree to pay the call option holder a fixed price for the underlying asset purchase.
3. Expiry Date: The option contract requires exercise within the specified time period known as the expiry date.
4. Premium: The option writer receives this specific payment for selling an option contract.
5. Contract Size: Every option contract contains a specified quantity of its base asset, also known as contract size.

Types of Call Writing

Call writing is classified into two types: Covered Call Writing and Naked (Uncovered) Call Writing, each with distinct risk and return characteristics.

1. Covered Call Writing

Covered call writing means selling a call option while holding the related asset simultaneously. This strategy is usually employed by investors seeking extra income from their stock portfolio.

 Benefits of Covered Call Writing

• Regular income generated from option premiums.
• Provides a small cushion against minor price declines in the stock.
• Appropriate for neutral or slightly bullish market situations.

Example:

• An investor owns 100 shares of Reliance Industries Limited (RIL), currently trading at ₹2,500 per share.
• The investor sells a call option with a strike price of ₹2,600 for a premium of ₹50 per share.
• Contract size: 100 shares
• Total premium received: ₹5,000 (₹50 × 100)

Possible Outcomes:

2. Naked (Uncovered) Call Writing

Naked call writing occurs when the seller writes a call option without owning the underlying asset. This strategy is riskier since potential losses are theoretically unlimited if the asset price rises sharply.

Risks of Naked Call Writing:

• Unlimited Loss Potential: The losses can be substantial if the stock price rises significantly.
• Margin Requirements: Naked call writing requires higher margin deposits due to the associated risk.
• Early Assignment Risk: The writer may need to fulfill the contract before expiration.

Example:

• A trader sells a Nifty 50 call option with a strike price of ₹22,000 for a premium of ₹150 per lot.
• Lot size: 50 units
• Total premium received: ₹7,500 (₹150 × 50)

Possible Outcomes:

Payoff Schedule in Call Writing

A payoff schedule in call writing outlines the potential profits and losses based on different underlying asset prices at expiration. It systematically presents the call writer’s financial outcomes for various market conditions, considering the strike price, premium received, and stock price at expiry.

For a covered call, the writer benefits from the premium if the stock remains below the strike price but risks losing potential upside gains if the stock price surges past the strike. The risk is theoretically unlimited for a naked call as prices can rise indefinitely, leading to significant losses.

Payoff Chart in Call Writing

A payoff chart visually represents the call writer’s financial gains and losses across stock price levels. The x-axis typically shows the underlying asset’s price at expiration, while the y-axis displays the corresponding profit or loss. For a short call position, the chart illustrates a capped profit (equal to the premium received) when the stock price stays below the strike price, while losses grow as the price moves higher.

The breakeven point occurs when the stock price equals the strike price plus the premium, beyond which losses escalate. This graphical representation helps traders assess potential risks and rewards before executing call-writing strategies.

Disadvantages of Call Writing

While call writing offers income potential, it also comes with risks that traders must carefully manage. The profit is limited to the premium received, and in certain cases, losses can be significant, especially in naked call writing.

1. Limited Profit Potential

The maximum profit in call writing is restricted to the premium received. Unlike buying options, where gains can be unlimited, call writers do not benefit from significant upward movements in the underlying asset.

2. Unlimited Losses in Naked Calls

Selling uncovered (naked) calls carries the risk of substantial losses if the asset price rises sharply. Since there is no holding in the underlying asset, the seller may be forced to buy at a much higher price to meet contract obligations.

3. Early Assignment Risk

Option buyers have the right to exercise their contracts before expiry. If this happens, the call writer must deliver the underlying asset at the strike price, which may lead to unexpected obligations and potential financial strain.

End Note

Call writing is a powerful strategy in options trading, wherein one can earn premiums and manage risk. Be it covered or naked call writing, knowing the market condition, risk potential, and strategic application is essential to maximise gains. While covered call writing is more secure and gives an income hedge, naked call writing requires disciplined risk management because of very high-risk exposure. With disciplined execution and sound risk assessment, it can serve as an effective instrument for portfolio performance enhancement through periodic returns.