Short Call Trading Strategy

When Is It Used?

As a bearish strategy, the short call is used when your expectation is that a security will go down in price. As it can only make limited profits, regardless of how much the underlying security actually goes down in value, it's best to use it when you are only expecting a small price drop. There are better strategies to use if you are expecting a big fall in price, such as the long put.

You should note that this strategy offers you no protection if the underlying security rises in price instead of falling, and losses can be quite substantial if it rises by a lot. As such, it should really only be used when you are very confident that the underlying security isn't going to go up in price.

How is a Short Call Transacted?

This strategy is simple enough to execute; you need to place a sell to open order to write call options contracts that are based on the underlying security which you believe is going to fall in price, thus entering a short position on those contracts. You'll need to decide upon the strike and the expiration date of the contracts before you write them, and this is something you need to put a little bit of thought into.

The majority of traders will write contracts that are either at the money, or very near to the money, with a relatively short time until expiration. This approach means that you can profit without the underlying security having to fall by much, and this also means that there's less time for something to go wrong (i.e. the price of the security going up instead).

You can increase your potential profits from the short call by writing more expensive contracts, such as those with lower strike prices or those with a longer time until expiration. This would increase your exposure to risk though, so such an approach requires careful consideration. You could go the other way, and write cheaper contracts with a higher strike or an even shorter time until expiration. This would decrease the risks involved, but I would also reduce the credit received for writing the contacts, and thus reduce your maximum potential profit.

Potential Profits & Potential Losses

When you use the short call you establish a credit position, which effectively means you get your profits up front in return for the liability you take on for writing the calls. However much you receive for writing them is the maximum profit you can make, and you will get to keep that money if they expire out of the money. That is basically how you make money while using this strategy. If the underlying security falls in price sufficiently for the calls to expire worthless, then your profit is the payment you received at the time of writing them.

If you write at the money contracts, then you will make money even if the underlying security doesn’t fall in price, providing it doesn’t go up in price either. If you write out of the money contracts, then you can even make a profit if the underlying security does go up a little, providing it doesn’t go up as high as the strike. If you write in the money contracts, then you will need the underlying security to fall below the strike.

Whatever type of contracts you write, you will need them to expire out of the money to get the maximum profit. However, you don’t have to wait for them to expire and you can use the buy to close order to buy them back at any point. So if the price of the underlying security dropped a little bit, but you were worried it might rally and gain in price again, you could buy back the contracts at that point. Your profit would then be the difference between the price you received for writing them and the price you paid for buying them back.

The risk here is that underlying security can, of course, not fall in price as expected, but increase in price instead. Should this happen, any contracts you have written could be assigned which would mean you would be obligated to sell the underlying security to the holder of the contracts at the agreed strike. Therefore, you would have to first buy the security, at the current trading price, and then sell it at a loss.

As such, this strategy carries substantial risk. If there is a sharp rise in the price of the underlying security, then you could potentially lose a lot of money. This risk is why the strategy requires margin, and why you will need a high trading level to use it. It's also why we advise beginners against using it.

Advantages & Disadvantages

It's important to weigh up the advantages and disadvantages before deciding whether or not to use this strategy. While there can be little doubt that it's very effective for profiting from a small, quick drop in the price of a security, the disadvantages cannot be ignored.

A particular benefit is that you receive money at the time of applying the strategy, because writing options generates an immediate return. However, you are taking on a significant liability in exchange for that return and the margin will be required. You'll have to allocate some of your capital for the margin requirements.

Another advantage is that it's a relatively simple strategy that requires just one transaction to be applied and doesn't cost much in the way of commissions. On the other hand, a high trading level is required which means it may not be viable for some traders. It's also very risky, because if the underlying security does unexpectedly go up in price, then you can be exposed to big losses.

Although you can always buy the options back if this looks like it's happening, you absolutely need to be aware that you can lose a lot of money with this strategy if your expectation turns out to be wrong.

Example

Here we have provided a basic example of applying a short call, and what some of the potential outcomes could be. We should point out that this example is for illustrative purposes and doesn't necessarily contain precise calculations and doesn't take into account the cost of commissions.

Initial Trade

• Company X stock is trading at $50, and you expect the price to fall a little.
• At the money calls on Company X stock (with a $50 strike price) are trading at $2.
• You write 1 call options contract (one contract contains 100 options) and receive a payment of $200.

If Company X stock falls below $50 by expiration

The calls you have written will be worthless at expiration and therefore you will have no further liability. The $200 payment you received for writing the contract is retained as your profit.

If Company X stock remains at $50 by expiration

With the calls being at the money at expiration, they will be worthless. Again, you keep the $200 initial payment as your profit.

If Company X stock increases to $52 by expiration

The calls are in the money, and you will have a liability (the options could be assigned or you could buy them back just before expiration). In this case, the liability will be around $2 per option for a total of $200. As you received a $200 upfront credit, you will have roughly broken even.

If the price of Company X stock went higher than $52, then you would start to make losses. As we have already pointed out, you could cut your losses at any time by buying the calls back. Although you would still make a loss by doing this, you would at least prevent any further losses that a continued increase in the price of the underlying security would lead to.

Profit, Loss & Break-Even Calculations

• Maximum profit is limited, per option written, to “Price of Option”
• Maximum profit is made when “Price of Underlying Security < or = Strike Price”
• Maximum loss is unlimited
• Loss is incurred when “Price of Underlying Security > (Strike Price + Price of Option)”
• Loss per option written is “Price of Underlying Security – (Strike Price + Price of Option)”
• Break-even point is when “Price of Underlying Security = (Strike Price + Price of Option)”

Summary

This is an effective strategy when used in the right circumstances, but it does come with significant risks. You really need to be very confident that a security will fall in price and believe that it's very unlikely that it will increase in price if you are going to use this strategy.

We would certainly recommend that beginners stay away from it, despite the fact that it's relatively simple to use, and would also suggest that risk averse traders consider alternatives that don't have such high potential losses.