The short call option strategy, also known as the uncovered or naked call, entails selling a call without owning the underlying stock. Short call options should be avoided by those who are new to options because they are a high-risk strategy with limited profits.
More advanced traders use a short call to profit from unique situations where they receive a premium for taking on risk. Let’s take a more in-depth look at the short call option strategy.
When the forecast for the underlying asset is negative to neutral, investors initiate the short call strategy. If the buyer of the short call exercises the option, the trader is obligated to sell the stock at the strike price.
- This is not to be confused with a short put option, in which the seller is obligated to purchase the stock at the strike price. In the chart above, the trader begins to lose money if the stock advances past strike price A.
- Wait until the strike price is one standard deviation out of the money (the stock price is lower than the strike price) before implementing this option strategy.
- With a short call, the trader wants the implied volatility (IV) to decrease as this will reduce the price of the options they’re short.
Here, if the investor decides to close the position before the expiration date, the trade will cost them less to buy back. Similarly, decreasing time to expiration is also a positive factor with this strategy because the less time to expiration, the lower the value of the call option, enabling the investor to close the position for less.
When Should You Use a Short Call?
The other alternative is to purchase put option contracts. In exchange for a premium, the seller of a call option bets that the stock will not rise over a certain price (strike price) before the option expires.
- This type of bear market trade is frequently entered when a stock has already had a significant run to the upside, particularly in a short period of time, and technical indicators, such as RSI or Percent-R, indicate that it is overbought.
- By selling a short call, the trader becomes bound to the option’s buyer, ensuring that they will deliver the stock to the call option’s buyer if the stock rises above the strike price.
- If the stock price remains below the strike price, the holder of the short call option keeps the entire premium as profit.
If the stock price rises above the strike price, the long call holder will exercise the option, forcing the short call holder to buy the shares at the current market price and deliver it to them at the lower price.
Profit/Loss
Maximum Profit = Net Premium Received
The greatest loss for a short call strategy is infinite because the stock can continue to rise indefinitely.
Breakeven
A short call option’s breakeven is computed by adding the premium to the strike price.
If a company is selling at Rs.100 and an investor wants to sell a call with a strike price of Rs.110 for Rs.2.00, the breakeven point is Rs.112.00.
Example
If the stock moves up to Rs.115, they will be required to buy the shares at Rs.115 and then return it to the call buyer at Rs.110, losing Rs.5.
However, because the option seller paid Rs.2 for selling the call, their net loss is Rs.3. If, on the other hand, the stock continues to fall or never hits Rs.110, the trader retains the Rs.2 premium as profit.
Conclusion
The short call option strategy is ideal for experienced investors who wish to profit by selling volatility when markets are overbought. The premium received decays over time, allowing investors to keep the entire premium or repurchase it later at a cheaper price.
- Aside from individual companies, some investors like to sell call index options. One justification for trading index options is that they are thought to be less volatile than individual stocks.
- Profitability with this method is restricted owing to the unlimited risk involved if the stock continues to rise. Traders prefer to sell calls because the potential reward is considerable if the option is far out of the money and the trade is properly timed.
If an investor expects a stock to fall in price, he or she might consider a bear call spread. This allows the investor to earn by selling at a premium while also allowing them to lose money if their analysis is incorrect.
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