Short Call

From CEOpedia | Management online

Short call is an option contract that imposes the obligation to its writer to sell the specific asset at the strike price on or before the expiration date.

By selling a short call, the option writer grants the option buyer the right to purchase the underlying at the exercise price. The writer receives a bonus and acquires the obligation to sell the underlying in the case of an assignment (S. Jovanovic, p. 142).

It's one of the strategies from which you can build more complex patterns. It's selling the right to purchase the underlying instrument at a fixed price, the seller has a contract to provide the underlying instrument at an agreed price (P. Moles, N. Terry, p. 395).

Call is the type of option that gives the holder the right to buy a specific amount of underlying collateral at a certain price for a specified period of time, the act of exercising a call option (The Securities Institute of America, Inc., p. 221).

You can distinguish two options:

  • long call - an option contract that gives its holder the right but not the obligation to buy a specific asset at the strike price on or before the expiration date (S. Jovanovic, p. 136);
  • short call (covered - if an investor owns the underlying that would need to be delivered in the event of an assignment, and naked - if an investor doesn't own the underlying) (G. Pruitt, J. Hill, p. 232).

Synthetic short call

synthetic short call - an option strategy obtained by hedging a short underlying with short put (S. Jovanovic, p. 179)

To create a synthetic short call, reverse the synthetic long call position by shorting shares and sales. Both the synthetic short call and short call have the potential for unlimited risk on the upside. You can replicate them by shorting the stock and selling a put at the same strike price and expiration date. The short stock portion of the synthetic short call requires more margin than the short call alone. The only benefit that a synthetic short call has in comparison with the other is that you can reinvest the proceeds of short selling shares.

Both are extremely risky positions and are not recommended unless combined with other positions (G. Jabbour, P. Budwick, p. 45, 46).

Examples of Short Call

  • A short call option is when an investor sells a call option with the anticipation that the underlying security will remain below the strike price or the option will expire worthless. In this case, the investor will collect the option premium for selling the call but will not have to buy the underlying security at the higher strike price.
  • For example, assume an investor owns 100 shares of ABC Company and is expecting the stock price to remain below $30 over the next month. The investor could sell a call option with a strike price of $30 and a month expiration for $2. If the stock price stays below $30, the investor will keep the option premium as profit. On the other hand, if the stock price rises above $30, the investor will be obligated to sell the 100 shares of ABC Company at $30.
  • Another example of a short call occurs when an investor buys a put option and sells a call option with the same strike price and expiration date. The investor profits when the underlying security trades between the strike price of the call and put, but loses money if the stock price drops below the strike price of the put.

Advantages of Short Call

The short call strategy has a number of advantages that can be utilized by traders. These include:

  • Limited Risk: By entering into a short call position, the maximum amount of risk that can be incurred by the trader is limited to the premium paid for the option. This is because the underlying security’s price cannot exceed the strike price plus the premium.
  • Leverage: The short call strategy allows the trader to gain leverage on their capital without the use of margin. This allows the trader to potentially profit from large price movements in the underlying security without having to invest a large amount of capital.
  • Potential for Time Decay: The short call position allows the trader to benefit from time decay, as the time value of the option will erode as the option approaches its expiration date. This can allow the trader to lock in profits if the option does not get exercised.
  • Ability to Hedge: The short call strategy can be used to hedge against long positions in the underlying security. This allows traders to limit the amount of risk they are taking by protecting the downside of their long position.

Limitations of Short Call

Short call options have a few limitations that traders should consider before entering into a position. These limitations include:

  • Limited Profit Potential - When entering into a short call position, the maximum profit potential is limited to the premium received. Once the underlying asset reaches the strike price, the premium received is the highest amount that can be made.
  • Unlimited Risk Potential - When entering into a short call position, the potential for losses is unlimited since the asset price can rise beyond the strike price.
  • Time Decay - The option value declines over time, which is unfavorable for short call traders. As the expiration date approaches, the short call trader will realize a decrease in the option value and is more likely to incur losses.
  • Market Volatility - Market volatility can cause the underlying asset’s price to move quickly, making it difficult to accurately predict the direction of the asset’s price. This can lead to unexpected losses for short call traders.

Other approaches related to Short Call

A Short Call is one way to capitalize on the volatility of the market and its potential for profit. There are several other approaches to utilizing options in the markets, such as:

  • Put/Call Spreads: This strategy involves buying and selling a call option and put option at the same time, resulting in a spread that reduces the overall cost of the trade and limits the trader's risk.
  • Covered Calls: This is a strategy that is used when a trader buys a stock and then sells a call option on the same stock. This enables the trader to benefit from any increase in the stock price, but also allows them to collect a premium from the call option if the stock price does not rise or if it drops.
  • Protective Puts: This strategy is used when a trader buys a stock and also buys a put option on the same stock. The purpose of this is to protect the investor from a drop in the stock price, while still allowing them to benefit from any increase in the stock price.

In summary, a Short Call is only one of the numerous strategies available to traders when it comes to utilizing options in the markets. Other approaches include Put/Call Spreads, Covered Calls, and Protective Puts. Each of these strategies has its own benefits and risks and should be carefully considered before being implemented.

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Author: Katarzyna Sieczkowska