If your analytics tell you a bear market is ahead, you might be thinking about trying to make money from the market with a short call options strategy.
Effectively, you are putting up your bet about the neutral or downward trend of the market against someone else’s bet of a rise in the market.
Here’s a closer look at a short call option and how you can either sell or buy short calls.
What Is a Short Call Option?
A short call options strategy means that you’re entering into a contract to sell a buyer the underlying security at a specified price by a predetermined date. This specified price, called the strike price, is above the current stock price when the option is sold, and you expect it to remain there.
If you’re selling a short call option, or naked call, that means you’re bearish about the market and expect the price of the option’s underlying security to decline.
The buyer, on the other hand, expects the security’s price to increase. Through the contract, you must sell the buyer the security if the he or she exercises the short call option. However, the holder has no obligation to buy the security if it never hits the strike price.
When you write, or sell, a call option, the buyer of said option pays a premium up front. This premium is your maximum profit if the security’s price doesn’t move above the strike price and the option expires.
The short call option’s profit is limited to the premium, but it has the risk of potential unlimited loss.
How the Strategy of a Short Call Option Plays Out
You write a short call option for a buyer. The call gives the buyer the right to buy the underlying security at the strike price before the contract expires.
The buyer pays you a premium, obligating you to deliver the shares if the buyer exercises the option. An options contract holds 100 shares.
The best thing for you is that the security’s share price never moves above your strike price, the contract expires worthless, and you profit from the premium.
However, if the share price moves above the strike price before the contract expires, the holder can exercise the option, and you must sell the buyer shares of the security. This means you must go into the market, purchase the shares at a their current price and sell them to the buyer at the lower strike price.
Short Call Option Examples
If you’re bearish on a hypothetical XYZ company, you sell a short call option at $75 at a premium of $6 for three months. XYZ’s stock never reaches $75 in three months, and the contract expires worthless. You make a profit of $600 (100 shares * $6=$600).
Or say XYZ’s stock moves up to $85 before the three months are up. The buyer exercises the option. Now, you have to buy 100 shares at $85 to sell to the buyer at $75. The buyer pays you $7,500 for the shares you bought for $8,500 and turns around and sells the shares into the market for a profit. Accounting for your $600 premium, you lost $400. However, since share prices have no limit to how much they can increase, your risk for loss with a short call strategy is essentially limitless.
Selling and Buying a Short Call Option
Here are the steps to selling a short call option:
- Place a sell-to-open order with your broker.
- The order will be filled at the asking price or the minimum you’re willing to accept.
- Once the call option is sold, your options account will be credited.
- For the riskiness of the trade, your broker may hold a margin against your account.
Buyers can find options through option chains via their broker, trading platforms or by entering market orders with a broker.
Should You Add the Short Call Options Strategy to Your Toolkit?
With awareness of market conditions, short call options can help you profit in a down market, but consider your exposure to unlimited losses if the market moves against you.
On the date of publication, Sarah Edwards did not have (either directly or indirectly) any positions in the securities mentioned in this article. The opinions expressed in this article are those of the writer, subject to the InvestorPlace.com Publishing Guidelines.
On the date of publication, the responsible editor did not have (either directly or indirectly) any positions in the securities mentioned in this article.
