Short Call Explained

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Explaining Call Options (Short and Long)

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What is a Call Option?

A call option is the right to buy the underlying futures contract at a certain price.

Buying Calls

When traders buy a futures contract they profit when the market moves higher. The call option has a similar profit potential to a long futures contract. When prices move upward the call owner can exercise the option to buy the future at the original strike price. This is why the call will have the same profit potential as the underlying futures contract.

However, when prices move down you are not obligated to buy the future at the strike price, which is now higher than the futures price because that would create an immediate loss.

With this downside protection why would any trader buy a futures contract instead of call?

The potential to profit on a call option does not come without a cost. The seller or “writer” of the option will require compensation for the economic benefit given to the option owner. This payment is similar to an insurance policy premium and, is called the option premium. The buyer of a call option pays a premium to the seller of a call option.

As a result of the added cost of the premium, the profit potential for a call is less than the profit potential of a futures contract by the amount of premium paid. The price of the future must rise enough to cover the original premium for the trade to be profitable. Moreover, options premiums are impacted by time decay and changes in volatility (futures are not).

The breakeven point for a call is the strike price plus the premium paid. So if you paid 4.50 points for a 100 call option, the breakeven is 104.50. The most you could lose is the premium or 4.50 points.

Selling Calls

For every long call option buyer, there is a corresponding call option “writer” or seller. If you sell the call option, then you receive the premium in return for the accepting the risk, that you may need to deliver a futures contract, at a price lower than the current market price for that future.

Option sellers have unlimited risk if the futures price continues to rise.

Call sellers will profit as long as the futures price does not increase beyond the value of the premium received from the buyer.

The breakeven point is exactly the same for the call seller as it is for the call buyer.

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Summary

Call Buyers have protection in that their risk is limited to the premium they must pay for the call option. The maximum risk of a call option is the premium paid. They can lock in the strike price and profit (should the underlying rise far enough) while risking only the upfront premium paid.

Short Call (Naked Call) Options Trading Strategy Explained

Published on Wednesday, April 18, 2020 | Modified on Wednesday, June 5, 2020

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Short Call (Naked Call) Options Strategy

Strategy Level Advance
Instruments Traded Call
Number of Positions 1
Market View Bearish
Risk Profile Unlimited
Reward Profile Limited
Breakeven Point Strike Price of Short Call + Premium Received

Short Call (or Naked Call) strategy involves the selling of the Call Options (or writing call option). In this strategy, a trader is Very Bearish in his market view and expects the price of the underlying asset to go down in near future. This strategy is highly risky with potential for unlimited losses and is generally preferred by experienced traders.

The strategy involves taking a single position of selling a Call Option of any type i.e. ITM or OTM. These naked calls are also known as Out-Of-The-Money Naked Call and In-The-Money Naked Call based on the type you choose. This strategy has limited rewards (max profit is premium received) and unlimited loss potential. When the trader goes short on call, the trader sells a call option and earn profits if the price of the underlying asset goes down. The trader receives the premium when he sells the call option. This premium is the maximum profit trader gets in case the price of underlying asset falls.

Let’s assume you are bearish on NIFTY and expects its price to fall. You can deploy a Short Call strategy by selling the Call Option of NIFTY. If the price of NIFTY shares falls, the call option will not be exercised by the buyer and you can retain the premium received. However, if the price of NIFTY rises, you will start losing money significantly and rapidly on every rise.

This strategy has unlimited risk and limited rewards.

How to use the short call options strategy?

The short call strategy looks like as below for NIFTY which is currently traded at в‚№10400 (NIFTY Spot Price):

ITM Naked Call Order – NIFTY

Orders NIFTY Strike Price
Sell 1 ITM Call NIFTY18APR10200CE

Suppose NIFTY shares are trading at 10400. If we are expecting the price of NIFTY to go down in near future, we sell 1 NIFTY Call Option to implement this strategy.

If NIFTY falls as we expected, the call options will not be exercised by buyer and we will keep the premium received at the time of selling the call option. This is also the maximum profit in this strategy.

If NIFTY rises, the losses are unlimited. This makes it extremely risky strategy. This strategy should be used very carefully with bracket orders (stop loss).

When to use Short Call (Naked Call) strategy?

It is an aggressive strategy and involves huge risks. It should be used only in case where trader is certain about the bearish market view on the underlying.

Example

Example 1 – Stock Options (OTM Naked Call)

Let’s take a simple example of a stock trading at в‚№48 (spot price) in June. The option contracts for this stock are available at the premium of:

Lot size: 100 shares in 1 lot

  1. Sell July 50 Call = 100 * 3 = в‚№300 Premium Received

Net Credit: в‚№300

Now let’s discuss the possible scenarios:

Scenario 1: Stock price remains unchanged at в‚№48

  • Sell July 50 Call: Expires Worthless
  • Net credit was в‚№300 which was received as premium initally.
  • Total profit = в‚№300 as we keep the premium.

The total profit of в‚№300 is also the maximum profit in this strategy. This is the amount you received as premium at the time you enter in the trade.

Scenario 2: Stock price goes up to в‚№68

  • Sell July 50 Call expires in-the-money with an intrinsic value of (50-68)*100 = -в‚№1800
  • Net credit was в‚№300 which was received as net premium.
  • Total Loss = -1800 + 300 (Premium Received) = -в‚№1500

In this scenario, we lost total в‚№1500. The loss could be significantly higher if the price of the stock keeps rising further.

Scenario 3: Stock price goes down to в‚№28

Same as scenario 1:

  • Sell July 50 Call: Expires Worthless
  • Net credit was в‚№300 which was received as premium initally.
  • Total proft = в‚№300 as we keep the premium.

Example 2 – Bank Nifty

Short Call Example Bank Nifty
Bank Nifty Spot Price 8900
Bank Nifty Lot Size 25
Short Call Options Strategy
Strike Price(в‚№) Premium(в‚№) Total Premium Paid(в‚№)
(Premium * lot size 25)
Sell 1 ITM Call 8800 500 12500
Net Premium 500 12500
Breakeven(в‚№) Strike price of the Short Call + Net Premium
(8800 + 500)
9300
Maximum Possible Loss (в‚№) Unlimited Unlimited
Maximum Possible Profit (в‚№) Net Premium Received * Lot Size
(500)*25
12500
On Expiry Bank NIFTY closes at Net Payoff from 1 ITM Call Sold (в‚№) @8800 Net Payoff (в‚№)
8800 0
(8800-8800)*25
12500
12500-0
9000 -5000
(8800-9000)*25
7500
12500-5000
9200 -10000
(8800-9200)*25
2500
12500-10000
9400 -15000
(8800-9400)*25
-2500
12500-15000
9600 -20000
(8800-9600)*25
-7500
12500-20000

Market View – Bearish

When you are expecting the price of the underlying or its volatility to only moderately increase.

Actions

  • Sell Call Option

Breakeven Point

Strike Price of Short Call + Premium Received

Break even is achieved when the price of the underlying is equal to total of strike price and premium received.

Risk Profile of Short Call (Naked Call)

Unlimited

There risk is unlimited and depend on how high the price of the underlying moves.

Reward Profile of Short Call (Naked Call)

Limited

The profit is limited to the premium received.

How can I tell the difference among long call, long put, short call and short put?

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This can easily get confusing. Always remember the following:

Long means buy
Short means sell

To be long a call means you are buying a call option. This is a bet that prices will rise.

To be short a call means you are selling a call option. This is a bet that prices may fall. Although, many people “write call options” (short calls) when they are long the underlying security in the hopes of profiting from low price volatility.

To be long a put means you a buying a put option. This is a bet that prices will fall.

To be short a put means that you are selling a put option. This is an in.

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