Benefits, risks and examples of a short call option.
A short call option is a bearish strategy used by investors to profit from neutral to declining prices in an underlying asset. This article looks at the short call option strategy, including its mechanics, benefits, risks, and practical implementation.
What is a call option?
A call option is a contract that gives the buyer the right, but not the obligation, to purchase a specified quantity of an underlying asset at a predetermined price (the strike price) before or at the expiry date. The buyer pays a premium to the seller (writer) of the call option for this right. Buying call options is known as a long call.
In return the seller has the obligation to deliver, upon the request of the buyer, a specified quantity of an underlying asset at a predetermined price (the strike price) before or at the expiry date. This position is known as a short call and is further explained in this article.
Both buyers and sellers of call options can terminate either their right or obligation by a reverse (closing) transaction.
Understanding the short call option strategy
A short call option strategy involves selling (writing) a call option with the expectation that the underlying asset's price will either remain steady or decline. The strategy profits from the premium received from selling the call option, which can be kept if the option expires worthless. This strategy is considered bearish to neutral.
Key components of a short call option
- Premium
The price received by the seller for writing the option. - Strike price
The predetermined price at which the buyer can purchase the underlying asset. - Expiry date
The date by which the option must be exercised or will expire worthless.
Advantages of the short call option strategy
- Immediate income
The primary benefit is the immediate income received from the premium. This can provide a steady stream of income if executed regularly and successfully. - High probability of success
If executed correctly, many short call options expire worthless, allowing the seller to keep the premium. This can result in a high probability of success in sideways or declining markets. - Flexibility
The strategy can be tailored by choosing different strike prices and expiry dates, allowing the seller to adjust their risk and reward profile.
Risks of the short call option strategy
- Unlimited risk
The most significant risk is the potential for unlimited losses if the underlying asset's price rises substantially. This makes risk management crucial. - Margin requirements
Selling call options typically requires a margin account, and the margin requirements can be substantial, especially if the stock price moves against the position. This margin is used as a buffer and provides a level of security to the clearing organisation that you are able to cover potential losses. - Opportunity cost
If the underlying asset appreciates significantly, the seller misses out on potential gains and faces losses.
Example of a short call option
Suppose you believe Company XYZ's stock, currently trading at €50, will not rise above €55 over the next three months. You decide to sell a call option with a strike price of €55 expiring in three months. You receive a premium of €2 per share (options typically represent 100 shares, so the total premium received would be €200).
Profit and loss potential of a short call
- Maximum profit
The maximum profit is limited to the premium received. In this example, the most you can make is €200 if the stock remains below €55 until expiry. - Breakeven point
The breakeven point occurs when the stock price equals the strike price plus the premium received. In this case, the breakeven price would be €57 (€55 strike price + €2 premium). - Unlimited loss potential
If the stock price rises significantly above the strike price, the potential loss is theoretically unlimited. For example, if XYZ's stock rises to €70, the loss would be (€70 – €55 – €2) x 100 = €1,300.
Implementing the short call option strategy
- Market analysis
Conduct thorough market analysis to identify stocks or assets expected to remain stable or decline. This can involve technical analysis, fundamental analysis, or both. - Select the strike price and expiry date
Choose a strike price that reflects your market outlook and an expiry date that aligns with your expectations for the stock's movement. - Monitor the position
Regularly review the position and market conditions. Be prepared to take action if the underlying asset's price moves significantly. - Exiting the position
Have a clear plan for exiting the position. This can involve buying back the call option to close the position if the stock price rises or letting the option expire if the price remains below the strike price.
Short call vs. other strategies
The short call option strategy is often compared to other strategies like short selling, long call options, and covered calls.
Versus short selling
Both strategies benefit from price declines, but short selling involves borrowing and selling the stock, which can be more complex and carry its own risks, such as the potential for unlimited losses and margin calls.
Versus long call options
A long call benefits from price increases and has limited risk (the premium paid), while a short call benefits from price decreases or stability but carries unlimited risk.
Versus covered calls
A covered call involves owning the underlying stock and selling a call option against it. This limits the risk compared to a naked short call, as the stock ownership can offset potential losses.
Practical tips to increase the possibility for success
- Risk management
Given the unlimited risk, it's crucial to have robust risk management strategies in place. This can include setting stop-loss orders, using options spreads, or limiting the size of positions. - Use technical indicators
Indicators such as moving averages, resistance levels, and volatility indices [CA3] can help identify potential entry points and manage positions. - Stay informed
Keep abreast of market news, earnings reports, and other factors that can influence the underlying asset's price. - Diversify
Spread your positions across different assets to mitigate the impact of adverse price movements in any single asset. - Regular review
Continuously monitor and adjust your positions based on market conditions and new information.
The short call option strategy can be a powerful tool for generating income in neutral to declining markets. However, it carries significant risks, especially if the price of the underlying asset rises substantially. By understanding the mechanics, benefits, and risks, and by implementing the strategy with careful market analysis and robust risk management, investors can potentially achieve consistent returns. As with any investment strategy, thorough research and prudent decision-making are essential for success in options trading.
Investing in the financial markets requires a deep understanding of various strategies to maximise returns while managing risk. Please consult your bank or broker for advice or read the Key Information Document to get a better understanding of all risks and costs involved.