A short call is an options trading strategy where a trader sells (writes) a call option. This gives the buyer of the call option the right, but not the obligation, to buy the underlying security at a specified price (strike price) within a predetermined timeframe. The seller of the call option (the short call writer) receives a premium in exchange but assumes the risk if the security’s price rises above the strike price.
Mechanism of a Short Call
In a short call, the trader:
- Sells a Call Option: The trader sells a call option contract to the buyer.
- Receives Premium: In return, the trader receives a premium from the buyer.
- Obligation to Sell: If the buyer exercises the option, the trader must sell the underlying security at the agreed strike price.
Mathematically, the profit/loss (P/L) of a short call can be expressed as:
- \( K \) is the strike price.
- \( S_T \) is the spot price of the underlying at expiration.
- \( C_{premium} \) is the premium received for selling the call option.
Types of Short Calls
There are two primary types of short calls:
-
Naked Short Call
- The trader does not own the underlying asset.
- Potential for unlimited loss if the stock price rises significantly.
-
Covered Short Call
- The trader owns the underlying asset.
- Losses are limited as the trader can deliver the owned stock if the option is exercised.
Risks and Rewards
Benefits
- Premium Income: The primary benefit is earning the premium from the call option sale.
- Bearish Outlook: Profits if the price of the underlying asset stays the same or declines.
Risks
- Unlimited Loss: Especially in naked short calls, the potential loss is unlimited as the underlying asset’s price can rise indefinitely.
- Margin Requirements: Traders may face significant margin requirements due to the high risk involved.
Practical Examples
Example 1: Successful Short Call
- Underlying Stock: XYZ Corp
- Current Price: $50
- Strike Price: $55
- Premium Received: $2
If XYZ Corp’s price remains below $55 until expiration, the call option expires worthless. The trader keeps the $2 premium as profit.
Example 2: Unsuccessful Short Call
- Underlying Stock: XYZ Corp
- Price at Expiration: $60
- Strike Price: $55
- Premium Received: $2
The trader incurs a loss of $3 per share ($60 - $55 - $2 received premium = -$3).
Historical Context
Options trading dates back to ancient civilizations, with recorded use in ancient Greece. However, modern options trading and strategies, such as the short call, became structured with the establishment of options exchanges like the Chicago Board Options Exchange (CBOE) in 1973.
Applicability
The short call strategy is typically used by:
- Advanced Traders: Who have a bearish view on a stock.
- Income Seekers: Looking for consistent premium income.
Related Terms
- Put Option: An option granting the right to sell a security at a predetermined price.
- Strike Price: The set price at which an option holder can buy or sell the underlying security.
- Premium: The price paid by the buyer to the writer of the option.
FAQs
What is the difference between a short call and a long call?
Can you close out a short call position before expiration?
References
- Hull, John C. “Options, Futures, and Other Derivatives.” Pearson, 2017.
- Chicago Board Options Exchange. “Understanding Options.”
Summary
A short call is an options trading strategy that involves selling a call option, providing potential income through the premium received but also posing significant risks if the underlying asset’s price rises. This strategy is best suited for advanced traders with a bearish market outlook and a comprehensive understanding of options trading mechanics and risks.
