One of the more common call options you will come across is the ‘short call’. This article will explain what it is while also differentiating it from other call types.
In finances, it is not unusual to see the term ‘call option’ being thrown around. These are agreements that provide the option buyer with the right – not the obligation – to purchase a stock. Additional things that they are able to buy are bonds, commodities, and any other instruments. They can often purchase these at a specific price within a specific period of time.
The stock, bond, or commodity that is up for purchase is the ‘underlying asset’. A call buyer will profit whenever the underlying asset experiences an increase in price.
Definition of a short call
A ‘short call’ option position is when the writer doesn’t possess an equivalent position in the underlying security. To elaborate, they do not own a position that their options contracts are indicative of. Conducting a short call is an options trading strategy wherein the trader is betting that an asset they’re placing the option on is going to decrease in price.
Basically, when you short a call option, you are selling it before you go forward and purchase it. That transforms the whole transaction in a way that reverses the mechanics of it. From this, you can make money, but only if the call option price drops before the contract expiration.
How it works
From a broader perspective, a short call strategy is one of two ways for options traders to attain bearish positions. It typically involves the selling of call options (otherwise known as calls). Calls grant the holder of the option with the privilege of purchasing underlying security at a specific price.
Should the price of the underlying security experience a drop, then a short call strategy will subsequently profit. If the price were to rise, then there is boundless exposure during the time in which the option is applicable. This is what is called a ‘naked short call’. In order to limit losses, some traders will apply a short call while owning the underlying security. This is a ‘covered call’.
Naked Short and Covered: What’s the Difference?
To provide further context, and to separate the two from a short call, let’s briefly dissect these types of calls.
A ‘naked call’ is an options strategy that involves an investor writing (selling) call options on the open market. This is without actually having official ownership of the underlying security. Evidently, this is in contrast to a covered call strategy. With that one, the investor does, in fact, own the underlying security on which the call options are written.
This strategy gives an investor the capability of revenue generation without formally possessing the underlying security. In essence, the premium they receive is the primary incentive for writing an ‘uncovered call’ option. It is inherently risky, due to there being a limit of upside profit potential. Moreover, in theory, there is no limit to the downside loss potential.
A ‘covered call’ (also ‘buy-write’) is among the more popular options strategies that can generate income for an investor’s account. Specifically, in the form of premiums. In order to properly execute this, an investor holding a long position in an asset needs to write call options on that same asset. This will effectively produce an income stream.
This is a neutral strategy. This means that the investor anticipates a minor increase or decrease in the underlying stock price of the written call option. It’s especially useful whenever an investor has a short-term neutral view on the asset. Because of this, it holds the asset long. Moreover, it simultaneously possesses a short position by way of the opportunity to generate income from the option premium.
Uncovered: what’s the difference?
With the establishment of what a covered call is, what about an ‘uncovered call’? Well, this is an options strategy where investors write options contracts without holding an offsetting position in the underlying asset. The investor writes this call whenever they don’t have the ownership of a long position in the underlying asset. When investors write an uncovered put, this means that they do not hold a short position in the underlying asset. This is a naked option.
An uncovered (or naked) put strategy is risky on account of there being a limit of upside profit potential. On top of that, it has the potential of a significant downside loss, at least in theory. This risk is due to maximum profit being achievable if the underlying price closes at or above the strike price. Additional cost increases in relation to the underlying security will not lead to extra profit.
Hypothetically, the maximum loss is significant considering that the price of the underlying security can potentially drop to zero. The higher the strike price becomes, the higher the loss potential becomes as well.
Example of these sell call options
Now that the differences are clear, it only makes sense that we illustrate how short calls work with an example.
Let’s say that Company A wants to sell calls on shares of Company B to Company C. The stock is trading close to $100 a share and is in a considerably strong uptrend. In spite of this, Company A is of the belief that Company B is overvalued. Furthermore, drawing from a mixture of fundamental and technical reasons, they believe it may drop to $50 a share. Company A ultimately agrees to sell 100 calls at a rate of $110 a share. This effectively gives Company C the ability to buy Company B’s shares at that specific price.
Selling the call option is what will allow Company A to collect a premium upfront. That is to say, Company C will pay liquid $11,000 (100 x $110). Should the stock heads gradually lower, as Company A believes, then they will profit on the difference. Specifically, between what they will receive and the overall price of the stock.
Let’s assume that Company B’s stock drops to $50. If this is the case, then Company A will obtain a total profit of $6,000 ($11,000 – $5,000).
There is the possibility of things going amiss, though. If Company B’s shares continue to ascend, then this will result in the creation of limitless risk for Company A. Let’s say that the shares persist with their uptrend, going up to $200 in the span of a few months. If Company A goes through with executing a naked call, Company C can carry out the option and buy stock worth $20,000 for $11,000. This will inevitably result in a trading loss for Company A that’s up to $9,000.
Calls vs. Puts
For a concise breakdown, a ‘call’ refers to an option contract giving owners the right to purchase a specific amount of underlying security. Moreover, they can buy it at a specific price within a specified time frame.
Conversely, a ‘put’ is an option contract grants a contract owner the right to sell a specific amount of underlying security. A similarity emerges in that this is done at a specific price within a specific time frame. Evidently, this concept diverges from a call option in a noticeable way, despite sharing a resemblance or two.
For more substance to this comparison, we will examine short calls and long puts.
A short call strategy is one of two of the most common bearish trading strategies. The other strategy is purchasing put options or puts. As previously mentioned, put options permit holders to sell a security at a certain price within a specific time frame. There is more to this though, and that is ‘going long on puts’, as traders usually put it. This is also a bet that prices will drop; however, the strategy operates a little differently.
To go further with this, let’s bring back the example from before.
Imagine that Company A still believes that Company B’s stock will fall. However, they instead choose to purchase 100 $110 Company B puts. To properly do this, Company A must put up the $11,000 ($110 x 100) in cash for the option. Company A now has the ability to force Company C – who resides on the other side of the deal – to buy the stock. This is regardless if Company B’s shares were to suddenly drop to Company A’s projected $50 a share. If they do, then Company A will have made a solid profit of $6,000.
In some sort of way, it’s achieving the same goal. The primary difference here is that this achievement comes from using the opposite route. Obviously, the long put requires Company A to distribute the funds upfront. The advantage here is that, unlike the short call, most Company A can lose is $11,000. To elaborate, this is the total price of the option.