A short call, also known as a sell call, is a trading strategy where an investor sells a call option with the expectation that the underlying asset's price will decrease.
This approach is commonly employed in bearish markets or when a trader believes that a particular stock or asset is overvalued. By selling the call option, the trader receives a premium upfront but assumes the obligation to sell the asset at the specified strike price if the buyer of the call option decides to exercise it.
BEARISH OR NEUTRAL OUTLOOK
A short call strategy is typically employed when an investor has a neutral or slightly bearish outlook on the underlying security.
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It is a strategy that benefits when the price of the underlying security either remains stable or decreases.
LIMITED PROFIT POTENTIAL
The maximum profit you can make from a short call strategy is the premium received when selling the call option.
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Once you've received the premium, your profit potential is capped, even if the price of the underlying security rises significantly.
RISK MANAGEMENT
Given the unlimited risk potential of a short call strategy if the stock price rises significantly, risk management is crucial.
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Traders often set stop-loss orders or have other risk mitigation strategies in place to limit potential losses.
PROS | CONS |
Income Generation: The primary advantage of a short call strategy is the ability to generate income. When you sell a call option, you receive a premium from the buyer. If the option expires worthless (out of the money), you keep the premium as profit. | Unlimited Risk: One significant drawback of a short call strategy is the unlimited risk. If the price of the underlying asset rises significantly, your losses can theoretically be unlimited. This is because there is no cap on how high a stock's price can go. |
Market Neutral or Bearish Position: This strategy can be used in a neutral or bearish market outlook. If you believe the price of the underlying asset will not rise significantly, selling call options allows you to profit from stable or declining prices. | Limited Profit Potential: The maximum profit from a short call strategy is limited to the premium received. Even if the price of the underlying asset drops significantly, your profit is still capped at the premium. |
Time Decay: Time decay, or theta decay, works in your favor with a short call strategy. As time passes, the value of options tends to decrease, and if the call option expires worthless, you can keep the premium. | Margin Requirements: Writing call options typically requires margin, which ties up capital and introduces the potential for margin calls if the trade goes against you. |
Flexibility: You can use this strategy alone or in combination with other positions to create more complex options trading strategies. | Assignment Risk: If the price of the underlying asset rises and the call option is exercised, you may be forced to sell the underlying asset at the agreed-upon strike price, potentially missing out on further upside potential. |
Market Volatility: High volatility can be detrimental to a short call strategy. Sharp and unpredictable price movements can increase the likelihood of the option being exercised.
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Opportunity Cost: If the price of the underlying asset rises significantly, you may miss out on potential profits that you would have gained by holding the asset instead of writing the call option. |
SHORT CALL AND OPTION ASSIGNMENT
In a short call scenario, assignment risk arises when the short call option gets exercised by the option holder. If the short call option is exercised, the trader who sold the option is obligated to sell the underlying asset at the specified strike price. This could result in the trader having to deliver the underlying shares or buy them at the market price to fulfill the obligation.
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For short call positions, assignment risk typically occurs if the price of the underlying asset is above the strike price of the short call option at expiration.
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In such a case, the buyer of the call option may choose to exercise it to buy shares at the lower strike price.
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To manage assignment risk, traders employing short call positions may consider the following strategies:
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Close Out Before Expiration: If it becomes likely that the short call will be in the money (i.e., the price of the underlying asset is above the strike price), traders can choose to buy back the call option before expiration. This action can help avoid the risk of assignment altogether.
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Roll the Position: Alternatively, traders can roll the position by buying back the existing short call and simultaneously selling another call option with a later expiration date and/or different strike price. This strategy allows traders to extend their position in time while potentially adjusting the strike price, thereby managing the assignment risk.
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By employing these strategies, traders can mitigate the potential complications and costs associated with assignment while maintaining control over their bearish view in the market through the short call position.
SHORT CALL EXAMPLE
Suppose an investor holds a bearish view on the SPDR Dow Jones Industrial Average ETF Trust (DIA) for the upcoming nine days. Envisioning the stock's current trade at $347.47 per share, the strategy chosen to express this bearish outlook involves the execution of a short call strategy. In this scenario:
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Sells for $2.46 one call option with a strike of $347.50 expiring in nine days
This strategic move results in a net credit of $2.46 for the single option, derived from the sale of the $2.46 credit. Considering the standard equivalence of one options contract to 100 shares of the underlying asset, the overall credit accumulated stands at $246.
MAXIMUM PROFIT SCENARIO
Suppose DIA experiences a downtrend, reaching $347.50 at the time of expiry. This results in the attainment of maximum profit, amounting to $246. This is obtained from the initial credit from the sale of the call position, and then multiplying the result by the number of shares (100). Hence, $2.46 multiplied by 100 shares equals the peak profit of $246.
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$2.46 x 100 shares = $246
It's important to note that once the stock surpasses the lower strike price, the strategy plateaus, and no additional profit accrues beyond this point.
MAXIMUM LOSS SCENARIO
Should the DIA shares hover at $347.50 or rise above the designated lower strike, the maximum loss comes into play. Yet, this loss will continue forever until the position is closed or assigned and then multiplied by 100 shares.
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Unlimited Potential Loss
The investor's undesirable scenario envisions the stock concluding above the $347.50 per share mark upon expiration, thus marking the potential loss for this investor of unlimited loss.
BREAKEVEN POINT
To find the breakeven point for a short call spread, you add the net credit received to the strike price of the sold call option.
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Strike Price: $347.50
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Net Credit Received: $2.46
Therefore, the breakeven point for this short call spread strategy is $349.96 per share. This means that if the price of DIA rises to or above $349.96 by expiration, the investor will start to incur losses. Below $349.96, the investor remains profitable up to the maximum profit of $246 achieved when DIA is at or below $347.50 at expiry.
The short call strategy presents a strategic option for investors with a bearish or neutral stance on an asset, leveraging the expectation of stable or declining market conditions. By selling call options, traders can generate income upfront while managing risk through various strategies like closing out positions or rolling them over. Although it offers limited profit potential, this approach benefits from time decay and can be complemented with other trading strategies for enhanced flexibility and risk management. Whether aiming to maximize profit or mitigate potential losses, mastering the short call strategy can provide a competitive edge in navigating market volatility and uncertainty. Thank you for exploring this strategy with us, and we look forward to assisting you further in your trading journey.
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- Explaining call options (Short and long) - CME Group. (n.d.-b). www.cmegroup.com/education/courses/introduction-to-options/explaining-call-options-short-and-long.html.
- Team, C. (2023b, November 22). Short call. Corporate Finance Institute.corporatefinanceinstitute.com/resources/derivatives/short-call/.
- Short call - uncovered. (n.d.). www.schwab.com/learn/story/short-option-primer-on-selling-options.
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