How to Survive a Recession

LESSON 22: Write Call Options

Call writing is a strategy best used during the beginning and middle stages of a recession when the stock market is falling.

A call option is an insurance contract that pays out if the price of the underlying stock goes above the "strike" price.

The first seller of a call option is called a “call writer” -- literally the party that writes up the option contract to sell to a potential buyer. The call writer receives an up-front "premium" and is responsible for paying the call buyer if the stock price rises above a stated price (the "strike" price).

To make a profit, call sellers (writers) bet that one or more of the following will occur:

a) the price of the underlying stock will fall below the strike price and the option will expire worthless,

b) the volatility of the underlying stock will fall, causing the option price to fall, or

c) time sensitivity will cause the price of the option to fall as expiration nears.

In a downward trending market typical of a recession, one or more of the above three events is likely to occur, resulting in a profit to the call seller (writer).

A call writer receives the buyer’s cash premium up front, puts it in the bank to earn interest, then waits in the hope that the option will expire worthless and he can keep the entire premium plus interest. Alternately, the call writer hopes the option price will fall so he can buy an offsetting call option and pocket the difference between the sale and purchase price.

Call writers face potentially unlimited risk if price of the underlying stock rises instead of falls. Since there is unlimited potential risk with "naked" call writing, most retail brokers will only allow “covered” call writing where the call writer already has the underlying shares in his or her account. Covered call writing can be used to generate current income to offset the fall in stock price, and to hedge against market drops without having to sell your shares and incur capital gains taxes. The goal is to generate regular current cash flows, rather than major profits.

It is critical when writing call options that you properly time the sale to minimize the potential for the underlying stock to go up in price or volatility instead of down. Premiums rise and fall with the price and volatility of the underlying asset, time to expiration, and supply and demand of call options. The ideal conditions in which to write a call option include high volatility, long time until expiration, strike price above the current price of the asset, and price in an upward correction during a major market downtrend. These conditions happen often during recessions as sporadic good news appears in the sea of bad news, or major institutional traders cover short positions for a few days to lock in profits.