SHORT CALL: Best Easy Guide to Master Short Call Strategy

short call

In finances, the term ‘call option’ is a common term used. One of the most common call options one can come across is the ‘short call option’. In this article, we will see what this call option is all about using examples. We will also look at the short-call option’s payoff.

First of all, we are to look at what call options mean. Call options are agreements that provide the option buyer with the right to purchase a stock. Other things that they can buy are bonds, commodities, and any other instruments. Oftentimes, they purchase these at a specific price within a specific period.

The stock or commodity that is up for purchase is the ‘underlying asset’. A call buyer will make profits whenever the underlying asset experiences a price increase.

What are Short Call Options?

A short call is a call options trading strategy in which the trader bets that the price of the asset on which they are placing the option is going to drop. It is a strategy that obligates the call seller to sell a security to the call buyer at the strike price if the call is exercised.

A short call is a bearish trading strategy. It involves more risk but requires less upfront money than a long put, another bearish trading strategy. It is also known as the naked or uncovered call.

How the Short Call Strategy Works

Naked Call

Selling the call needs you to sell stock at strike price A when you assign the option.

When you are running this strategy, you want the call you sell to expire worthlessly. That’s the reason why most investors sell out-of-the-money options.

This strategy has a low-profit potential when the stock remains below strike A at expiration. However, it is an unlimited potential risk if the stock goes up. Most traders often run this strategy because there is a high probability of success when selling out-of-the-money options. So, if the market goes against you, you must have a stop-loss plan put in place.

You may also consider ensuring that strike A is around one standard deviation out-of-the-money at initiation. This will increase your probability of success. However, the higher the strike price, the lower the premium you can receive from this strategy.

Historically, indexes have not been as volatile as individual stocks. Hence, some investors may want to run this strategy using index options rather than options on individual stocks. Fluctuations in an index’s component stock prices can cancel one another out, lessening the volatility of the index as a whole

NOTE: Uncovered short calls are only suited for the most seasoned options traders. It is not a strategy for the lily-livered.

Basic Returns

Strike A plus the premium received for the call. There’s a large sweet spot. As long as the stock price is at or below strike A at expiration, you make your maximum profit. That’s why this strategy is enticing to some traders.

If the stock keeps rising above strike A, you keep losing money.

Risk is theoretically limitless. If the stock keeps rising, you keep losing money. You may lose some hair as well. So hold onto your hat and stick to your stop-loss if the trade doesn’t go as you planned.

NOTE: The premium gotten from establishing the short call may be applied to the initial margin requirement.

After this position is established, an ongoing maintenance margin requirement may apply. This means depending on how the underlying performs, an increase (or decrease) in the required margin is possible. You should also note that this requirement is subject to change and is on a per-contract basis. So don’t forget to multiply by the total number of contracts when you’re solving the math. For this strategy, time decay is your friend. You want the price of the option you sold to approach zero. That means if you choose to close your position before expiration, it will be less expensive to buy it back.

When the strategy is established, you want implied volatility to decrease. This will decrease the price of the option you sold. So, if you choose to close your position before expiration it will be less expensive to do so.

Read also: PUT OPTIONS: How to trade put options in simple steps

Example of Short Call Options

Now that the differences are clear, it only makes sense that we illustrate how short calls work with an example.

For example; Company A wants to sell short call options on shares of Company B to Company C. The bond is trading close to $120 per share and is in a considerably strong uptrend. However, Company A believes that Company B is overvalued. Furthermore, drawing from a mixture of fundamental and technical reasons, they believe it may drop to $60 per share. Company A eventually agrees to sell 100 calls at a rate of $105 per share. This should give Company C the maximum ability to buy Company B’s shares at that specific price.

In this example, selling the short-call options will allow Company A to collect a premium upfront. That is to say, Company C will pay liquid $10,500 (100 x $105). So when stock heads lower gradually, as Company A believes, then they will profit on the difference. Specifically, between what they will receive and the overall price of the stock.

Reverse Example

Let’s assume that Company B’s stock drops to $55. If this is the case, then Company A will obtain a total profit of $5,000 ($10,500 – $5,500).

However, in this short call option example above, there is the possibility of things going amiss, though. If Company B’s shares continue to rise, then this will result in the creation of limitless risk for Company A. So in this short call options example, the shares may continue with their uptrend, going up to $200 in the span of a few months. If Company A goes through with executing a short call, Company C can carry out the option and buy stock worth $20,000 for $10,500. This will inevitably result in a trading loss for Company A that’s up to $9,500.

Short Call Options Payoff

When you are looking to calculate the payoff for a short-call strategy, then you need to consider these major factors in your calculations;

  • The option price at the starting point
  • The option price is at the expiry point.

The initial option price is easily available. However, to calculate the option price at the point of expiration, you need to perform a quick subtraction of the underlying price from the strike price (OE). Now if the OE is more than 0, use that else user 0 as the opinion price at the expiry point. Thus your short call payoff is equivalent to the difference between the option price and OE as discussed above.

Short Call Payoff Diagram

short call options
Macro option

The payoff diagram of a short call position/strategy is the inverse of a long call diagram. You multiply the profit or loss by -1.

Read also: Sell Put Options Overview with Options Trading Examples

Short Call Options Payoff Formulas

The formulas are the same as those for the long call option strategy, only the profit or loss is multiplied by -1 because you are taking the other side of the trade.

There are again two components of the total profit or loss:

  • The initial option price
  • The value of the option at expiration

Short call payoff per share = initial option price – option value at expiration

Option value at expiration = MAX (0, underlying price – strike price)

Short call payoff per share = initial option price – MAX (0, underlying price – strike price)

Short call options payoff = (initial option price – MAX (0, underlying price – strike price ) x number of contracts x contract multiplier.

So we can see that the strategy is directional and bearish. Generally, it makes money when the underlying price goes down. It is also a short volatility strategy, as the value of a call option declines when volatility decreases. This means your short-call position becomes more profitable.

However, it has unlimited risk, because your total loss from the trade rises proportionally with the underlying price. Hence traders willing to trade with this option should endeavor to practice this trade with a demo. This will enable them to be able to manage the risks effectively.

Long Puts vs. Short Calls

A short call strategy, as previously stated, is one of two main bearish trading techniques. The alternative option is to purchase put options or puts. Put options give the holder the right to sell a security at a certain price and time frame. Going long on options, as traders call it, is likewise a wager that prices will decline, but the approach works differently.

Say Liquid Trading Co. still feels Humbucker stock will decrease but instead purchases 100 $110 Humbucker puts. To do so, the Liquid group must pay the $11,000 ($110 x 100) option premium in cash. Liquid now has the authority to compel Paper, who is on the opposite side of the transaction, to purchase the stock at this price – even if Humbucker shares fall to Liquid’s estimated $50 per share. If they do, Liquid will have made a nice profit of $6,000.

It accomplishes the same thing in some ways, but by taking a different path. Of course, the long put necessitates that Liquid pay money upfront. The upside is that, unlike the short call, the maximum Liquid may lose is $11,000, or the option’s total price.

The Benefits of Short Calls

The key benefit of a short-call strategy is its adaptability. An investor can set the strike price of a call option as high as he wants, increasing the likelihood that the option will not be exercised.

Disadvantages of Short Calls

  • The strategy’s maximum profit is restricted to the price received for selling the call option.
  • Because the underlying stock’s price can climb endlessly, the maximum loss is limitless.

The short-call strategy is associated with unlimited risk and just a limited opportunity for gain. This is especially true given that most equities improve in value over time.

Call Option VS Put Option: Key Difference

The key difference between the call and put options is visible in their definition.
While the call option represents the right to buy, the put option is the right to sell. Also, the call option grants buyers the option to buy underlying securities at a specific price within a specified time frame. And the put option allows the buyer to sell a predetermined number of shares of an underlying security at a predetermined price before the contract expires.

Conclusion

Every investment comes with certain risks. So you need to fully understand how the short call works before diving in to buy or sell with it. Also, the help of financial analysts may come in handy if want to consider this means of investment.

Short Call FAQs

What does short call mean?

A short call is a call option strategy in which the call seller is obligated to sell a security to the call buyer at the strike price if the call is exercised. A short call is a negative trading technique that represents a wager that the underlying security’s price will fall.

What is the difference between a short call and a long call?

A short call is a negative to neutral options trading strategy that capitalizes on the underlying asset’s downward price fluctuations as well as the passage of time (theta decay). A long call is a bullish options trading strategy that only profits from price increases in the underlying asset.

Is a short call bullish?

Long call and short put are bullish bets among the four basic option positions, whereas long put and short call are bearish trades.

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