What Is A Short Call & How It Works?

6 mins read
If you're interested in options trading, you may have heard of a short call. This options strategy can be a bit more complex, but it can also offer some significant benefits if done correctly.

The short call option strategy consists of selling a call without taking a position in the underlying stock. It is also called an uncovered or naked call. When an investor sells a call option on a stock because he expects that stock’s price to decrease in the future it is called a short call options strategy. It is the selling of a call option in which you are obligated to purchase the underlying asset in the future for a fixed price.

When the stock trades below the strike price sold it limits the profit potential and when the stock goes up above the strike price sold then it is exposed to greater risk. If you are an investor who is new to options trading, then you should avoid using a Short Call option strategy as it bears a high-risk level with limited profits. A short call is often used by more advanced traders to book profit from unique situations where they receive a premium for their risk-taking strategy. In this article, we will take a detailed look at the short call option strategy.

How a Short Call Works?

When the prediction of the underlying asset is bearish to neutral in nature then investors would open the short call trading strategy. Once the sale is executed, the trader has an obligation to sell the stock at the strike price and it is not to be confused with the short put option wherein the seller is obligated to buy the stock at the strike price. Once the stock moves past the strike price, the trader starts to lose their profit and when it moves past the strike price by more than the premium received, they start taking a loss.

In this strategy, the call option has no value at expiration thereby expiring becomes worthless based on the investor’s interest. When using the short call option strategy the best practice is to wait until the stock price is lower than the strike price at the time of executing this option strategy. That said, the more risk, the higher the reward as the strike price will negatively affect the premium received.

In a short call strategy, traders by and large want the implied volatility to decrease as this will reduce the price of the options they’re short. The trade will cost them less to buy back if the investor decides to close the position before the expiration date. Likewise, within this strategy decreasing the time to expiration is also a positive factor as less time to expiration leads to a lower value of the call option enabling the investor to close the position for less.

When to Execute a Short Call

One of the two option strategies which a trader can utilise when making a bearish bet on the market is the short call option strategy, while the other is the put option contracts. The seller of a call option calls his bet by predicting that the stock will not go over a specified value which is known as the strike price before the option expires in exchange for the collection of a premium. This sort of bear market trade occurs quite often when it is known that the stock has already undergone a big rally to the upside, and even its technical indicators such as RSI or Percent-R show that it has been overbought.

When performing a short call, the trader becomes obligated to the option’s buyer guaranteeing that they will deliver the stock to the buyer of the call option if the stock goes over the strike price. The short call option holder keeps the entire premium as profit if the stock price goes above the strike price and if the stock price rises above the strike price, then the long call holder will exercise the option and force the short call holder to go out into the open market and buy the stock at the current market price delivering it to them at a lower price.

Investors who already own stock most likely do not sell upside call options for additional income, known as a covered call. This ensures that if the stock does rise then the investor hands over the stock that’s already present in their portfolio.

Example of a Short Call 

We can better understand the short call option strategy with an example. Ms X is bearish about the Sensex and expects it to fall. She sells or shorts a call option with a strike price of ₹1,000 at a premium of ₹120 when the current Nifty is at 1,094. Now, if the Sensex stays at 1,000 or below, then the Call option will not be exercised by the buyer of the Call, and Ms X can retain the entire premium of ₹120.

Short Calls vs. Long Puts 

Long put:

A put option means the choice to sell an option at a predetermined date at the expiry time. As a strategy, it allows buyers a put option on expiry but not an obligation. The premium is paid to buy put options. When prices go down, investors exercise their options. If they exercise their option when the prices are up then they will encounter losses. So timing is vital in exercising these options. The best suitable time is when the market is highly bearish and expects to go down sharply.

Short Call:

Short Call also known as uncovered call or naked calls basically means selling a call option. Initially, it generates net credit by receiving premiums. The current market conditions help in determining the strategies so one needs to be aware of the market conditions. This approach is used by advanced traders because any inexperienced investor doing these options would encounter heavy losses. The strike price has an important significance in the success of a short call strategy. In order to get higher premiums, the strike price must be above the current price or close to the current market price. When traders are bearish towards the market, it is the ideal time to apply this strategy. FAQs

Can Short Call be considered if you are new to trading?

No. Short Call option strategy is a trading tactic used by experienced/advanced traders to yield gains from the bearish runs of the market. It is very crucial for new investors to be aware of the prevailing market conditions before venturing into this strategy.

Is the Short Call strategy ideal for achieving one’s retirement goals?

No. The Short Call option strategy in its entirety is not ideal for achieving retirement goals as it involves high levels of risk and the investor would often lose their investment capital while betting against the market conditions. At best, it could help investors to get high returns from their investments.

What kind of market conditions suit the short call strategy?

A Short Call option strategy would require the market to have a bearish run where prices of stock are falling down rapidly. In such conditions, investors would bet their money against the stock price and try to gain returns from its anticipated fall.

Is short call strategy riskier?

A short call is a bearish options strategy with undefined risk. Selling a call option is an alternative to selling shares of stock, and the seller receives payment when the option is sold.