Beginner's Guide to Selling Call Options: A Case Study of Shorting FTSE China

1. Basic Understanding of Selling Call Options

For those who have not come across options, it may be difficult to understand the concept of selling options. Common questions like “How can I sell an option if I don't have it?” or “What is the point of selling an option?” often arise. We can explain this using an analogy from real life — selling a second-hand car.

Let’s assume you have a second-hand car, and its current market price is 20,000 RMB. You believe that the car's price will not increase significantly in the next few months, so you decide to sell a call option.

• Buyer: Your friend B is interested in your car but does not have enough money to buy it right now. He hopes to have the option to buy your car at 20,000 RMB within the next three months.

• Seller (you): You sell a call option, agreeing to give your friend B the right to buy your car for 20,000 RMB within the next three months, and you receive 1,000 RMB as a premium for this right.

There are two possible scenarios:

1. Car price remains the same or decreases: If the market price of the car stays at 20,000 RMB or lower in the next three months, your friend B will not exercise his right because he can buy the car at the same or lower price in the market. You keep the car and receive the 1,000 RMB premium.

2. Car price increases to 25,000 RMB: If the price of the car increases to 25,000 RMB, your friend B will exercise his right to buy the car for 20,000 RMB. Although you sold the car at a lower price, you still received 20,000 RMB for the car and the 1,000 RMB premium, totaling 21,000 RMB. This is 1,000 RMB more than you initially received, but you missed out on the potential 5,000 RMB increase in value.

Returning to the stock market, since all assets in the capital market are priced based on fair value, the seller does not need to own the “second-hand car” to sell the call option. As long as they have sufficient funds to purchase the car in the market and fulfill the buyer's demand, they can sell the call option.

Selling a call option is equivalent to accepting a payment (premium) in advance for being willing to sell an asset at a fixed price at some point in the future. You can immediately receive the premium, but if the price increases significantly, you may miss out on higher profits.

2. YINN Sell Call Option Example

Let's use the recently popular YINN as an example. We executed a short YINN position on a simulated account.

Trade Details

• Trade Direction: Sell YINN call options with a strike price of 46, expiration date February 21 (naked call).

• Opening Time: February 18, YINN price 42.53 USD.

• Premium: 52 USD per contract, 10 contracts sold, total premium income of 520 USD.

• YINN Price on February 20 before market opens: 39.83 USD (below 46, options are almost worthless).

Profit and Loss Calculation

• Since YINN is significantly below the strike price of 46, the options are likely to expire worthless (0 USD).

• Current floating profit and loss (assuming the option price is close to zero):

  • Premium income: 520 USD (initial income).

  • Remaining obligation: Close to 0 (option value has dropped significantly).

  • Current profit: Approximately 520 USD (close to 100% return).

Risk Analysis

• This strategy is essentially a naked call (Short Call), and theoretically, the risk is unlimited (if YINN surges).

• However, since YINN's price is always below 46, the sold options are likely to expire worthless, maximizing the profit.

• If held until expiration and YINN stays below 46, the total premium of 520 USD from 10 contracts will be the final profit.

The return rate formula is:
Return Rate = 520 / 17,618 * 100% ≈ 2.95%
This is the return over 4 days. If annualized (assuming the strategy can be rolled continuously), the annualized return rate would be approximately 282%. This strategy has a high short-term return, especially when YINN does not rise significantly, allowing for continuous rolling and potentially higher annual returns.

Summary

• The current floating profit is 520 USD, with an ideal risk-reward ratio.

• If YINN remains below 46, holding until expiration will capture the full premium.

• If you want to lock in profits in the short term, you can close the position early and realize part of the profit.

• This strategy is suitable for a market environment where the underlying asset is expected to be flat or decline and can be rolled to continuously collect premiums.

Next Steps: If you continue to be bearish on YINN, you can sell new call options with a lower strike price, rolling to collect additional premiums.

• Selling a call option with a lower strike price: The premium will be higher because the lower the strike price, the higher the likelihood of the option being exercised, and the market will carry a higher premium.

• Selling a call option with a higher strike price: The premium will be lower because as the strike price increases, the likelihood of the option being exercised decreases, and the premium decreases accordingly.

3. Situations Suitable for Selling Call Options

Selling call options is typically suited to the following situations:

1. Bearish or Neutral Market
   Selling call options is appropriate when an investor holds a bearish or neutral view on the underlying asset. That is, the investor expects the price of the asset to not rise significantly and may even decline. By selling call options, the investor can earn premiums when the market declines or remains stable.

2. Stable Position Income
   If an investor already holds the underlying asset and expects minimal price fluctuations in the short term, they can sell corresponding call options (called "covered calls"). This allows them to generate additional income from the premium.

3. Hedging Strategy
   Selling call options can also be used as a hedging strategy. For example, if an investor has a short position in an asset (like short selling stock), they can sell call options to offset potential losses from the short position.

4. Income from Premiums
   Some investors sell call options primarily to earn the option premium. In cases where the investor does not have a strong view on the price direction, they can sell call options to earn a relatively stable income from premiums.

However, selling call options carries significant risks. If the price of the underlying asset rises above the strike price, the investor faces unlimited losses. Therefore, this strategy is suitable for investors with a higher risk tolerance and should be used with proper risk control measures.

4. Common Questions about Selling Call Options

1. How do I close a position after selling an option?
   After selling one contract, you have a position of -1. To close it, you need to buy one contract back. -1 + 1 = 0, so buying one contract will close the position.

2. How will the profit change during the holding period?
   Profit is influenced by both time and the stock price. As the expiration date approaches, the time value decreases slowly (benefiting the seller). The lower the stock price is below the strike price, the more the seller earns. If the stock price exceeds the strike price plus the premium, the seller starts to incur losses.

3. How do I calculate the breakeven point?
   Breakeven point = Strike Price + Option Premium.

4. How is the profit/loss different between holding to expiration and closing the position before expiration?
   Since options have time value, a contract held until expiration will have a time value of 0, while an unexpired contract retains some time value. If held until expiration, the option will expire and the seller keeps the full time value. Closing the position early will result in losing some time value.

5. What happens to the call option after expiration?
   If the underlying asset price is below or equal to the strike price at expiration, the buyer has no incentive to exercise the option, and it will not be exercised.
   If the price is above the strike price, the buyer can exercise the option to buy the asset at the lower strike price. If the seller has the asset, they must sell it at the strike price. If the seller does not have the asset, they will have to buy it at a higher price in the market and sell it at the strike price, resulting in a negative position in the corresponding stock.

This translation covers the full content, including the detailed explanation of the call option selling strategy, YINN example, and relevant questions regarding the strategy.