Introduction To Short Call Option Strategy
To short a call is to sell a call option without actually having ownership of it. With the right conditions in the underlying security, the call option could expire worthless and the trader collects the entire premium. This is similar to the shorting of shares. A trader can sell the shares at a high price and then buy it back at a lower price, thereby profiting from the price differential. Just like the short sale of shares, the whole idea is to short the call option at a high price and buy it back at a low price. The lowest price an option can go to is $0 and this happens when the call option expires worthless. This is also known as naked call writing.
Net Credit
Writing or shorting a call will result in a net credit.
Read : What does “net credit” mean in options trading?
Margin requirements for short call
A short call is considered an extremely risky strategy as there is unlimited risk to the upside. Hence, margin is required. The amount of margin required is subject to the broker’s discretion. In general, selling naked options have the highest margin requirements.
Read : Understand The Fundamentals Of Margin requirements
Steps
Step 1 : Perform economic, fundamental and technical analysis
Step 2 : Outlook – Bearish
Step 3 : Study the option chain
Step 4 : Breakeven Analysis
Step 5: Understand Your Profit Zones
Step 6 : Unlimited potential loss
Step 7 : Loss calculation
Step 8 : A strategy with limited profit
Step 9 : Calculate Profit
Step 10 : Calculate Risk & Reward Ratio
Step 11 : Set Up A Short Call
Step 12 : Exiting a short call position
Step 13 : Record Trade In Diary
Step 1 : Perform economic, fundamental and technical analysis
Perform economic, fundamental and technical analysis to ensure that the general direction of the underlying security is down. Some charts that a trader can look out for is:
Read : Basic Economic Analysis , Basic fundamental Analysis and Introduction to technical analysis
Step 2 : Outlook – Bearish
This strategy is used by traders who expect the price of the underlying security to fall. When that happens, the trader could earn the maximum profit when the option expires worthless. More specifically, the trader who uses the short call strategy is projecting that the price of the underlying security trades below the breakeven point of the strategy. However, trading below the breakeven does not guarantee the maximum profit. Trading below the exercise(strike) price of the shorted call will guarantee a maximum profit.
Step 3 :Study the option chain
Examine the options chain and get to know the call options and the potential premiums collected when written. Investigate implied volatilities and look out for options with high implied volatility. When implied volatility is high, option premium is also high.
Read : Learn to read and understand options chain
Step 4 : Breakeven Analysis
A short call has only 1 breakeven point. That breakeven point can be calculated as:
Exercise price + Option premium
Do note that the exercise price is the strike price.
Step 5: Understand Your Profit Zones
After calculating the breakeven point, the trader will know where the profit zone is on a payoff diagram of a short call.
Step 6 : Unlimited potential loss
The short call has the potential for an unlimited loss because the price of the underlying security could rise indefinitely.
Step 7 : Loss calculation
The loss occurs when the buying price is higher than the selling price. It can be calculated as:
Loss = Buying price of call – Selling price of call
The loss can also be calculated as:
Price of underlying security – Exercise price of call option – net credit + commissions paid to broker
Step 8 : A strategy with limited profit
The profit in a short call strategy is limited to the premium of the option collected when it was shorted.
Profit calculation for short call
If a call option contract was shorted at a price of $1 and bought to close at a price of $0.50, the trader has essentially earned $50 on that contract.
($1 – $0.50) x 100 = $50
Do note that each contract represents an underlying security of 100 shares.
Step 9 : Calculate Profit
The maximum profit can be calculated using the formula below.
Maximum Profit = Premiums collected – commissions paid
Step 10 : Calculate Risk & Reward Ratio
In a short call strategy, the risk is unlimited. Hence, the risk and reward ratio will not look attractive. However, if stop losses are in place, the options trader is able to estimate the risk and reward ratio. It would make sense for the trader to calculate the risk and reward ratio and see if the risk justifies the reward.
Read more : Understanding Risk/Reward Ratio For Option Traders
Step 11 : Set Up A Short Call
Write a naked call without ownership of the underlying security.
Step 12 : Exiting a short call position
- When the price of the underlying security falls below the exercise(strike) price of the call option, the call option will expire worthless. In a situation like this, the option trader gets to keep the premium of the written call less the brokerage commissions paid. This is the best case scenario for traders who write options – that is, options expire worthless.
- When the price of the underlying security rises, the trader can buy to close the short call position. He does this by buying an option with the same expiration and exercise(strike) price.
- If the price of the underlying security rises above the exercise(strike) price of the call, assignment will occur. The writer of the call ( the trader who has shorted the call) will have the obligation to buy 100 shares at current market prices for every written call contract and deliver it to the buyer of the call option. The difference between the current market price and the exercise(strike) price less the collected premium from writing the call is the loss that the trader incurs in the course of the trade.
Step 13 : Record Trade In Diary
After the trade has been exited, record it in a diary or a journal. Reflect on the trade and compare its performance to other trades of a similar nature. Strive to become a better trader.
Example Of A Short Call
A trader shorts 1 ABC 50 Jan call option contract @ $5. This means that the credit which the trader receives is equal to:
$5 x 100 = $500
This is so because each option contract is representative of 100 shares of the underlying security.
The breakeven point in this case can be calculated as:
$50 + $5 = $55
If the price of ABC trades below $50 on the expiration date of the options, the options will expire worthless and the trader gets to keep the credit received.
If the price of the underlying security trades above $55, the trader will make a loss.
Effect Of Dividends On A Short Call Strategy
When dividends are paid, the price of the call option will decline in general because the price of the underlying security will adjust downwards. This works in favor of a short call strategy.
Long call vs Short call
The long call is the opposing trade to the short call. While a long call has a potential for unlimited profit, the short call has the potential for unlimited loss.
Read : Long Call : Profit From Rise In Price Of Underlying security
Learn how a professional options trader/hedge fund manager writes naked options to increase returns