Many people thought this article made no sense, but some of you knew that it was spot on, so I've decided to reprise it and flesh it out a bit with directions about what calls do and don't do. It's going to be on a very elemental level, so if you don't know anything about puts and calls, you might get something out of it.
Selling an out-of-the-money call is not the same as selling the stock.
(When you own stock and you don't like it or think it's going down, you should sell it. If you think it's good and going up, you should own it. Another option is to sell a call against the stock, which is also known as writing a covered call option. Writing is a synonym for selling. A call is a method of capturing the upside with a defined downside risk. When you buy a call, you're trying to capture upside while containing the downside. The person who sells you the call is the writer of the call. People write calls ostensibly because they want to generate income while holding on to a stock. So, you own 5,000 shares of National Gift Wrap and it's at $30. You think it's going to mark time and it doesn't have a dividend. You might want to sell 50 calls against the stock to bring in some income. You could sell 30 calls, meaning that you could sell the right to the upside above 30. If it's April, you might want to sell a June call, to use an example, which might be valued at $3. You would raise $15,000 by doing that. Here's how that math works. Each call represents the right to 100 shares. Ten calls gives the buyer the right to 1,000 shares. Fifty calls is the right to 5,000 shares. Each call is worth $300. The shorthand for that is $3. You multiply the price of the call by the number of shares -- 5,000 -- and you get the amount raised: $15,000. How did the market come up with $3 per call? That's a function of the time of the call: how long the buyer has before it expires, the amount of fluctuation expected (known as the volatility), and the price of the stock. It's a sum of expectations over a defined time frame. The seller reaps the profit if the stock does nothing but go out at the strike -- $30 -- or below. The buyer makes out if the stock closes above $33, which is his breakeven ($30 plus $3 for the call equals $33). What happens if National Gift Wrap gets a $50 bid from International Paper between now and the third week of June, when the options expire? You get to keep the $15,000, but the buyer of the call gets everything from $33 to $50. What happens if the stock goes to $30.75 or more? The buyer automatically exercises her call, or her right to own the stock, and your stock is "called away." You lose your stock. You could, of course, buy the call back at any time if you didn't want that to happen. But if you were doing it to generate income, that may cause you to incur substantial transaction costs, as calls are illiquid. If the stock is running, the call might be "pumped," meaning that you would have to buy it for more than the $3 you sold it for. That can be a nasty loss. And if the stock drops to $23, say, you may think you're "protected," but the three points you pick up aren't equal to the $7 you lost from the decline. Worse, let's say the stock drops $7 and you want to buy the call back; it may not have gone down that much. You can't sell the common stock for fear that it might get that bid from International Paper. So a sold call could lock you into a loss situation. You lose control of your big asset if you sell something with a defined reward but no collar to the downside. That's a terrible risk-reward in my opinion. That's why I always say this is a failed strategy. It cuts off your upside -- terrible -- and doesn't limit your downside -- also terrible. Where I'm from, we have a word for that. It's stupid.)
I don't know how I can be more plain about that. Those who think they are taking it off the table by selling an out-of-the-money call are just kidding themselves. Those written calls will not protect you from downside. They will only make the ordeal more problematic.
(You might think, well, hold it, National Gift Wrap doesn't do a thing, so it's just as well that I keep selling calls every three months or so. Wrong! If you don't think a stock is going to do anything, sell it and buy another stock. Don't waste your capital. And if you think the stock is going to go down, what are you holding on to it for?)
I can't emphasize to you enough how my logic on this issue is both rigorous and empirical. As one of the largest options traders on the Street for years and years, I can tell you that if you think selling a call is protective, you are just smoking something that doesn't fly in my house.
(As someone who has traded options professionally for almost 20 years, I can tell you that I have done this strategy -- writing calls -- hundreds of times. The one or two times you get locked into a really bad loss are enough to convince you that you shouldn't do this ever again.)
In a severe market breakdown the price of the call you sold might actually expand as volatility can make calls more expensive. You can get the gain until you buy the calls in, but chances are the premium in the call will be so pumped up that you won't want to do that until it is too late and the common is so low that the call didn't make you enough money.
(I like to buy calls like this. Our best hit this week was to buy Intel (INTC) - Get Free Report calls when the stock was at $123. We bought the April 130 calls for about $5. Whoever was selling them probably thought they were "juicy." I thought that person was stupid. I got all of the upside of what could be a great quarter with a totally defined downside, something the common stock holder and call seller could never claim. I love buying that kind of call and I can't believe anybody would need the income so badly to write it.)
Brokers love it when you sell calls. It is a regular commission generator and you feel like you are doing something safe. You feel like you are taking stock off the table and raising cash.
(This was probably too cruel. There are many great full-service brokers who can facilitate these kinds of trades and until you've been on the big losing end of a write, you'll think it makes sense. I'm trying to keep you from doing it because I don't want you to find out the hard way. Or, think about it this way, what do I have to gain by telling you the wrong strategy? As someone who often buys calls, I should be thrilled for you to sell them, cheaply and stupidly. But that's not what this is about. Don't sell me those calls. Keep the upside to yourself.)
All you are doing is locking in a terrible trade if the market really takes a bath and cutting off your upside if it doesn't. That's the worst of all possible worlds. I know -- I have done it hundreds of times. Hundreds of times I found myself caught with a big decline in the common and a small gain in the short call. Hundreds of times I have cut off my upside or lost a common stock position before a big move because I wanted to pick up a few bucks selling an expensive call.
(Believe me, you own a stock for the upside. That's the best part. Don't try to create income while generating a lot of brokerage fees. Try to find a stock that will go up that you can follow, watch and be excited by. Not that you hope does nothing. You're betting against yourself with this strategy.)
Use me as your laboratory. I am not trying to make any money off you or gather assets from you or make commissions from you. I am just telling you the way it is. (I will rewrite this article this weekend for those who are lost in the terminology.)
James J. Cramer is manager of a hedge fund and co-founder of TheStreet.com. At time of publication, his fund had no positions in any stocks mentioned. His fund often buys and sells securities that are the subject of his columns, both before and after the columns are published, and the positions that his fund takes may change at any time. Under no circumstances does the information in this column represent a recommendation to buy or sell stocks. Cramer's writings provide insights into the dynamics of money management and are not a solicitation for transactions. While he cannot provide investment advice or recommendations, he invites you to comment on his column at