What is the difference between shorting a stock and selling a call to open?
Are the results pretty much the same. Seems to me like the only real difference is that you cover your short anytime whereas with selling an option to open you have to wait until it expires. Which method is less risky?
Shorting a stock is a process by which shares are borrowed then sold. These shares must be bought back at an undetrmined future date. The intent in doing this is to buy the shares at a price below where they were sold. If the market for this stock rises, a person may be forced to buy back at a higher price. In such a case a loss would be incurred.
Selling a call to open is essentially granting another person the right to “call away” or take a specified quantity of shares from you at a predetermined price. This price is known as the strike price. The objective of the seller (the person who is selling the call to open) is to capture the premium ( the amount that the buyer pays to secure the right to call away stock). The seller hopes that either the stock never reaches the strike price or that if it does the premium received exceeds the loss resulting from the stock rising above the strike price.
In selling short, the profit potential is the differece between where the stock was sold short and 0. In contrast, the profit potential for selling calls to open is the premium and no more.
In both instances, the potential loss is theoretically unlimited. As a shortseller you are responsible for covering the price movement from the point at which the stock was sold short to infinity . As a call writer, you are responsible for covering all price movement from the strike price to infinity.
Oftentimes people will write “covered” calls which means a person owns the stock for which the call is written. In such a case if the value of the stock rises, the stock is called away and the call buyer pays the strike price to the seller.
For example, a person buys 100 shares of XYZ stock at 20 dollars. He writes a call with a stike price of 22.50 and receives a premium of .50 . Subsequently the stock rises to 40 dollars. In such a case the stock would be called away at 22.50. The seller would receive the premium of .50 in addition to being paid 22.50 per share for his stock.
If the stock price dropped to say 17 dollars, the seller of the call would receive a premium of .50 and would still own the stock at 17.50.
Stock Trading – Shorting TWC for $1,000 –Meir Barak