Short Call Explained

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Short Call

What Is a Short Call?

A short call option position in which the writer does not own an equivalent position in the underlying security represented by their option contracts. Making a short call is an options trading strategy in which the trader is betting that the price of the asset on which they are placing the option is going to drop.

How Does a Short Call Work?

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 an underlying security at a specified price.

If the price of the underlying security falls, a short call strategy profits. If the price rises, there’s unlimited exposure during the length of time the option is viable, which is known as a naked short call. To limit losses, some traders will exercise a short call while owning the underlying security, which is known as a covered call.

Real World Example of a Short Call

Say Liquid Trading Co. decides to sell calls on shares of Humbucker Holdings to Paper Trading Co. The stock is trading near $100 a share and is in a strong uptrend. However, the Liquid group believes Humbucker is overvalued, and based on a combination of fundamental and technical reasons, they believe it eventually will fall to $50 a share. Liquid agrees to sell 100 calls at $110 a share. This gives Paper the right to purchase Humbucker shares at that specific price.

Selling the call option allows Liquid to collect a premium upfront; that is, Paper pays liquid $11,000 (100 x $110). If the stock heads lower over time, as the Liquid gang thinks it will, Liquid profits on the difference between what they received and the price of the stock. Say Humbucker stock does drop to $50. Then Liquid reaps a profit of $6,000 ($11,000 – $5,000).

Things can go awry, however, if Humbucker shares continue to climb, creating limitless risk for Liquid. For example, say the shares continue their uptrend and go to $200 within a few months. If Liquid executes a naked call, Paper can execute the option and purchase stock worth $20,000 for $11,000, resulting in a $9,000 trading loss for Liquid.

If the stock were to rise to $350 before the option expires, Paper could purchase stock worth $35,000 for the same $11,000, resulting in a $24,000 loss for Liquid.

Short Calls Versus Long Puts

As previously mentioned, a short call strategy is one of two common bearish trading strategies. The other is buying put options or 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 Liquid Trading Co. still believes Humbucker stock is headed for a fall, but it opts to buy 100 $110 Humbucker puts instead. To do so, the Liquid group must put up the $11,000 ($110 x 100) in cash for the option. Liquid now has the right to force Paper, who is on the other side of the deal, to buy the stock at this price – even if Humbucker shares drop to Liquid’s projected $50 a share. If they do, Liquid has made a tidy profit – $6,000.

In a way, it’s achieving the same goal, just through the opposite route. Of course, the long put does require that Liquid shell out funds upfront. The advantage is that unlike the short call, the most Liquid can lose is $11,000, or the total price of the option.

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Short Call

The converse strategy to the long call. The short call strategy involves the selling of call options. Selling of call options is more commonly known as call writing.

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How would you like to make a very healthy return from a stock that drops in value over the short term? If so, then consider the short call strategy.

As the name implies, when you short a call you’re selling it up-front. That not only means that you get a credit to your account right away, but also that you only earn a positive return when the call option price drops.

There are two ways that a call option price will decrease in value:

  • The price of the underlying stock drops
  • The price of the underlying stock stays roughly the same as you get closer to contract expiration (time decay)

Your percentage return depends on how much the call option price drops and its strike price.

In this guide, I’ll go over the short call strategy so you’ll know more about it and determine if it can help with your financial goals.

What Is a Short Call ?

When you short a call option, you’re selling it before you buy it. That turns the whole transaction around so that you make money only if the call option price drops prior to contract expiration.

It’s similar to shorting a stock except you have a deadline (when the contract expires).

Keep in mind: you also get a credit to your account immediately when you short a call. That credit is also your maximum profit.

If the call option is higher than the strike price at expiration, then it’s in the money. That means the person who bought that call option from you will expect you to sell shares of the underlying stock to him or her at the strike price.

You’ll need to buy shares of the stock so you can complete that transaction. Because the call option is in the money, you’ll sell those shares for an immediate loss.

Keep in mind: if the stock goes up dramatically, then you’ll take a significant loss. A short call is a very dangerous strategy because your loss is unlimited.

If the underlying stock stays below the strike price at contract expiration, then the option expires worthless. You keep the premium you earned from the sale of the call and make a nice profit.

When Would You Use a Short Call ?

Use a short call when you’re very bearish on a stock and would like to profit right away.

You should be very bearish on the stock to offset the risk. Remember: the underlying stock price can theoretically go up to infinity. You’d suffer a severe loss well before it gets anywhere near that point.

It’s a great idea to have a stop-loss order in place when you open a short call position.

How Does a Short Call Work?

First, make sure you have a margin account with your online brokerage. You’ll need that to place a short call order.

Why? Because you might have to purchase the underlying security and sell it again if the trade doesn’t go your way.

Once you have a margin account in place, it’s easy to short a call option. Just use your trading platform to find a stock that you think will drop in value in the short term.

Then, look at the options chains for that stock. Select an expiration date based on your time frame for the security to drop in price.

Next, pick your strike price. That’s the price that you believe the stock will never rise above at contract expiration.

Then, sell the call.

You’ll notice an immediate credit to your account. If the stock price is below the strike price at the expiration date, then you keep your premium as the option expires worthless.

Real Life Example Using a Short Call ?

Let’s say Coca-Cola is trading at $49.50 per share right now. You think it’s going to drop in the next month so you decide to short a call option.

You sell next month’s $50 call option for $0.58. Remember, though, that means the whole contract is worth $58 because options are traded in bundles of 100 shares.

So when you sell the shares you get an immediate credit of $58 ($0.58 x 100) to your account.

If you were right and Coca-Cola shares drop to $48 at contract expiration, then you keep the premium. In this case, that’s $58 minus commissions.

But what happens if you were wrong and Coca-Cola shares rise in value? You take a hefty loss.

If shares go up to $51 as you get closer to expiration, then you’d need to buy back the short call to close out the position. Otherwise, you’d have to buy shares of Coca-Cola only to turn around and sell them for a loss.

Let’s say the call option you sold trades at $1.30 a couple of days before expiration and you decide to close out the position. You buy back the call option for $130 ($1.30 x 100).

That gives you a total loss of $72 ($130 – $58).

Here are a few strategies similar to a short call:

  • Long Put – A long put is another options strategy that you’d use if you were bearish on the underlying stock, The biggest difference between a short call and a long put is that with a long put your loss is limited to the amount of money you spent on the put option.
  • Covered Call – A covered call is like a short call except that you already own the underlying stock. In that case, if the trade doesn’t go your way, you sell the stock that you own to the person who bought the call option from you.
  • Bear Call Spread – Similar to a short call except that you also buy a call option at a higher strike price to limit your loss.

Short Call C ompared to Other Options Strategies?

Plenty of options strategies use a vertical spread. That’s a way to hedge yourself against catastrophic losses.

However, there’s no spread with a short call. That’s why your loss is unlimited.

If you’re moderately bearish on a stock and would like to capitalize on a drop in value, consider opening a bear call spread so that you’re protected if the trade doesn’t go your way.

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