Unleashing the Power of Short Call Strategy
A short call is an options position taken as a trading strategy when a trader believes that the price of the asset underlying the option will drop. It’s considered a bearish trading strategy.
Short calls have limited profit potential and the theoretical risk of unlimited loss. They’re usually utilized by seasoned traders and investors.
Key Takeaways
- A call option gives the buyer the right to purchase underlying shares at the strike price before the contract expires.
- When an investor sells a call option, the transaction is known as a short call.
- A short call requires the seller to deliver the underlying shares to the buyer if the option is exercised.
- This is a bearish strategy aiming to profit from a decline in the underlying security’s price.
- The goal for the short call trader is to earn the premium and for the option to expire worthless.
Decoding How a Short Call Works
The short call strategy is a straightforward approach to capitalizing on a bearish market outlook. It involves selling call options, which grant the holder the right to buy the underlying security at a specified price (the strike price) before the contract expires.
The call seller, or writer, gains the premium paid by the buyer. If the buyer exercises the option, the seller must supply the underlying shares.
The success of this strategy hinges on the option expiring worthless. In this case, the trader retains the premium as pure profit. The option’s expired status means the position will no longer be in their account.
For the trader to succeed, the price of the underlying asset must dip below the strike price by the time the option expires. If it does, the buyer does not exercise the option, making it valueless.
If the asset’s price climbs, the option will be exercised since the buyer can acquire shares at a lower strike price and sell them at a higher market value for profit.
For the seller, there’s unlimited exposure while the option is active. If the asset’s price surpasses the strike price and continues to rise, the seller is obligated to provide the shares and may have to purchase them at a much higher market price, leading to substantial losses.
Selling a call without owning the underlying shares is a naked short call. To mitigate potential losses, some traders opt for a covered call strategy by owning the underlying asset or may settle their naked short position at a loss before the option gets exercised.
Example of a Short Call
Imagine that shares of Humbucker Holdings are trading at $100 and are in a strong upward trend. A trader, however, believes based on detailed analysis that the stock is overvalued and will eventually decline to $50.
With this perspective, the trader sells a call option with a $110 strike price for a premium of $1.00. They receive a net premium of $100. If the stock price drops, the calls expire unexercised, and the trader prospers fully from the premium as profit.
However, if Humbucker’s share price continues to climb, the risk to the call seller escalates. Suppose the shares jump to $200 within months. The call holder will exercise the option to buy at $110, and the seller must fulfill this by purchasing the shares at $200, incurring significant losses.
Here’s the calculation:
- Compra 100 shares at $200 each = $20,000
- Receives $110 per share from the buyer = $11,000
- Net Loss = $20,000 - $11,000 = ($9,000)
- Adjust with the premium $100: Total Loss = ($8,900)
Short calls can be very risky due to the possible losses if the contracts are exercised, necessitating high-value share purchases by the seller.
Short Calls vs. Long Puts
Another fundamental bearish strategy alongside the short call is purchasing puts. Put options grant the holder the right to sell a security at a determined price within a specified timeframe. If a trader buys a put with a $90 strike price for a $1.00 premium, the right is sold at $90, irrespective of how low the market price drops. If the market price stays above $90, the trader loses the premium spent.
Key Terms to Remember
What’s a Short Call?
Selling a call option is termed a short call, indicating selling a security they don’t own.
Why Sell Call Options?
Investors sell calls anticipating a security’s price drop for income from the premiums received, benefitting as long as options end up expiring unused.
Risks of a Naked Short Call
The risk includes high-potential losses if the security’s market price rises, necessitating expensive procurement to cover sold calls.
Related Terms: bearish strategy, call option, naked short, covered call, long put, strike price, option premium
References
- U.S. Securities and Exchange Commission. “Investor Bulletin: An Introduction to Options”.
