What is a Short Call?

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.

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.

Profits from Short Calls

The writer of the call option receives a fee (premium) for selling the call option. It is the only profit the writer can receive from the transaction.

Assume that:

p = Profit

K = Strike price

S = Stock price

c = Call price

If the underlying asset’s price is lower than or equal to the strike price at the expiration date, the holder does not exercise his option. The writer’s profit is equal to the price he received for selling the call option.

If S ≤ K, p = c

If the underlying asset’s price is greater than the strike price at the expiration date, the holder will exercise his option. The writer’s loss is equal to the loss he assumes because of the difference between the stock price and the strike price, net of the price received for selling the call option.

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If S > K, p = – (S – K) + c

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).

Advantage of Short Calls

The main advantage of a short call strategy is its flexibility. An investor may set the strike price of the call option as high as he wishes, increasing the probability that the holder will not exercise the option.

Disadvantages of Short Calls

  • The maximum profit of the strategy is limited to the price received for selling the call option.
  • The maximum loss is unlimited because the price of the underlying stock may rise indefinitely.
  • The short call strategy can be thought of as involving unlimited risk, with only a limited potential for reward. The fact is especially true since most stocks increase in value over the long term.

Example of a Short Call

Suppose the share price of HDFC Bank is trading at INR 1600. You expect the price to correct shortly. You decide to write a call option with a strike price of INR 1500 at a premium of INR 50. The lot size is 100 shares. You earn an upfront premium of INR 5000 from writing the option. INR 5000 is also the maximum profit potential from the trade.

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Now, if the market price of HDFC Bank on expiry is INR 1470 then the holder will not exercise the option. The reason is, that HDFC shares are available in the market for INR 1470 versus the contracted strike price of INR 1500. The option expires worthless and you earn INR 5000.

If the market price of HDFC Bank on expiry is INR 1550 then the holder will exercise the option. You make a loss of INR 50 per share i.e. INR 5000 for 100 shares. The loss is offset by the premium earned of INR 5000. If the market price of HDFC Bank falls below INR 1550 then you will incur a loss.