Short calls are a bearish trading strategy in the world of options. This article explains what short calls are, how they work, their potential risks and rewards, and provides real-world examples of their application.
What is a short call?
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. Therefore, it’s considered a bearish trading strategy. Short calls have limited profit potential and the theoretical risk of unlimited loss. They’re usually used only by experienced traders and investors.
How a short call works
A short call strategy is one of two simple ways options traders can take bearish positions. It involves selling call options, or calls. Calls give the holder of the option the right to buy the underlying security at a specified price (the strike price) before the option contract expires.
The seller, or writer, of the call option receives the premium the buyer pays for the call. The seller must deliver the underlying shares to the call buyer if the buyer exercises the option.
The success of the short call strategy rests on the option contract expiring worthless. That way, the trader banks the profit from the premium. The expired position will be removed from their account.
For this to happen, the price of the underlying security must fall below the strike price. If it does, the buyer won’t exercise the option.
If the price rises, the option will be exercised because the buyer can get the shares at the strike price and immediately sell them at the higher market price for a profit.
For the seller, there’s unlimited exposure during the length of time the option is viable. That’s because the underlying security’s price could rise above the strike price during this time, and keep rising. The option would be exercised at some point before expiration. Once that happens, the seller has to go into the market and buy the shares at the current price. That price could potentially be much higher than the strike price that the buyer will be paying.
A seller of a call who doesn’t already own the underlying shares of an option is selling a naked short call. To limit losses, some traders will exercise a short call while owning the underlying security. This is known as a covered call. Or, alternatively, they may simply close out their naked short position, accepting a loss that’s less than what they’d lose if the option were assigned (exercised).
Example of a short call
Say that shares of Humbucker Holdings are trading near $100 and are in a strong uptrend. However, based on a combination of fundamental and technical analyses, a trader believes that Humbucker is overvalued. They feel that, eventually, it will fall to $50 a share.
With that in mind, the trader decides to sell a call with a strike price of $110 and a premium of $1.00. They receive a net premium credit of $100 ($1.00 x 100 shares).
The price of Humbucker stock does indeed drop. The calls expire worthless and unexercised. The trader gets to enjoy the full amount of the premium as profit. The strategy worked.
However, things could instead go awry. Humbucker share prices could continue moving up rather than go down. This creates a theoretically limitless risk for the call writer.
For example, say the shares move up to $200 within a few months. The call holder exercises the option and buys the shares at the $90 dollar strike price. The shares must be delivered to the call holder. The call writer enters the market, buys 100 shares at the current market price of, it turns out, $200 per share. This is the trader’s result:
- Buy 100 shares at $200 per share = $20,000
- Receive $90 per share from buyer = $9,000
- Loss to trader is $20,000 – $9,000 = ($11,000)
- Trader applies $100 premium received for a total loss of ($10,900)
Short calls can be extremely risky due to the potential for loss if they’re exercised and the short call writer has to buy the shares that must be delivered.
Short calls vs. long puts
As previously mentioned, a short call strategy is one of two basic bearish strategies involving options. The other is buying puts. Put options give the holder the right to sell a security at a certain price within a specific time frame. Going long on puts, as traders say, is also a bet that prices will fall, but the strategy works differently.
Say that our trader still believes Humbucker stock is headed for a fall. They opt to buy a put with a $90 strike price for a $1.00 premium. The trader spends $100 for the right to sell shares at $90 even if the actual market price falls to $50. Of course, if the stock does not drop below $90, the trader will have lost the premium paid for the protection.
What’s a short call?
When investors sell a call option, the transaction is called a short call. Short is a trading term that refers to selling a security.
Why would someone sell call options?
Investors who believe that the price of a security is going to fall might sell calls on that security simply for income. In other words, they’ll profit just from the premium they received for selling the option. However, for the strategy to succeed, the option has to expire unexercised by the buyer.
What’s the risk of a naked short call?
A naked short call refers to a situation where traders sell call options but don’t already own the underlying securities that they would be obligated to deliver if the buyer exercises the calls. So, the risk is that the market price for the security goes up above the option strike price, the buyer exercises the option, and traders must enter the market to buy the securities for a price way above what they’ll receive for them (the strike price).
Here is a list of the benefits and the drawbacks to consider.
- Potential for profit from premium
- Strategy works if the option expires worthless
- Theoretical risk of unlimited loss
- Exposure to market price rise
Frequently asked questions
What is a short call?
A short call is an options trading strategy where an investor sells call options, betting that the underlying asset’s price will decrease. It’s considered a bearish strategy, reflecting a pessimistic outlook on the asset’s performance.
How does a short call differ from a long call?
While a short call involves selling call options to profit from a price drop in the underlying asset, a long call entails buying call options, anticipating an increase in the asset’s price. Long calls are a bullish strategy.
What are the key components of a short call strategy?
The key elements of a short call strategy include selling call options, receiving a premium, and hoping that the option expires worthless. If the underlying asset’s price remains below the strike price, the option typically won’t be exercised.
What’s the maximum profit potential in a short call strategy?
The maximum profit in a short call strategy is the premium received when selling the call options. This profit occurs when the options expire worthless, and the seller retains the premium as their gain.
What’s the risk of a short call?
The primary risk of a short call strategy is the potential for unlimited losses if the underlying asset’s price rises significantly above the strike price. In such cases, the option buyer may exercise the option, and the seller must purchase the asset at the higher market price to fulfill the contract.
Can a short call strategy be closed before expiration?
Yes, a short call position can be closed before expiration. Traders can buy back the call options they previously sold to effectively close the position. This move can help limit potential losses or secure profits if market conditions change.
What is a covered call, and how does it differ from a naked short call?
A covered call is a strategy where a trader sells call options on an underlying asset they already own. This strategy provides some downside protection, as the trader can deliver the owned asset if the call options are exercised. In contrast, a naked short call is when a trader sells call options without owning the underlying asset, exposing them to higher risks.
Are short calls suitable for all investors?
No, short calls are typically considered an advanced options strategy and may not be suitable for all investors. They require a solid understanding of options and the willingness to manage potential risks. Novice investors are often advised to gain experience with less complex strategies.
What market conditions are favorable for a short call strategy?
A short call strategy is most effective in bearish or neutral market conditions when the trader anticipates a decline in the underlying asset’s price or expects it to remain relatively stable. It’s essential to assess market trends and perform thorough analysis before implementing this strategy.
What’s the role of time decay (theta) in a short call strategy?
Time decay, represented by the Greek letter theta, works in favor of a short call strategy. As time passes, the value of the call option erodes, benefiting the seller. The goal is for the option to expire worthless, allowing the seller to keep the premium as profit.
- A call option gives the buyer of the option the right to purchase underlying shares at the strike price before the contract expires.
- When an investor sells a call option, the transaction is called a short call.
- A short call requires the seller to deliver the underlying shares to the buyer if the option is exercised.
- A short call is a bearish trading strategy, reflecting a bet that the security underlying the option will fall in price.
- The goal of the trader who sells a call is to make money from the premium and see the option expire worthless.