Short Call Option: What It Is and How to Create a Short Call Trade

One of the four basic option strategies is a Short Call trade. A short call position is created when the trader believes the price of the underlying asset will fall. It is a bearish strategy where the trader makes money when the asset price falls. However, it can result in unlimited losses if the asset price moves in the opposite direction.

Definition

A short call position is created by selling a call option when the trader expects the price of the underlying asset to drop,

The chart below shows the payoff diagram of a short call option.

As can be seen from the payoff diagram, short calls have limited profit potential and unlimited loss.

Suppose a short call position was created by selling a 18900 Call option at 85

As the lot size of Nifty is 50, the credit that the trader will receive by creating the position is Rs 4,250(85*50)

The maximum profit potential in this trade is Rs 4,250

Theoretical maximum loss = Infinity

The margin required for creating the trade is Rs 94,740

Breakeven = Strike Price + Premium collected = 18900 + 85= 18985

When to create a Short Call trade

A short call option is created with the view that the underlying asset's price may fall in the near term. Even if the underlying does not fall but stays where it is, the trade will be profitable because of Theta or time decay.

The trader will make money when the underlying asset stays below the strike price sold.

The probability of success for selling an option is high, especially when the trade is carried over a few days.

In case of a directional move downward, the trade benefits from being right on the direction (delta) and theta decay, while it profits from only theta decay if the asset stays where it is or stays below the breakeven point.

Traders can create a Short Call trade when they expect a downward slow move. In case of a sharp down move, buying a put option or other debit trading strategies offer better returns.

Traders also use the short call strategy to take intraday trades and use it in combination with other options to create multi-leg strategies.

Often, a Short Call strategy is used in a Covered Call trade. Here, the short call is combined with the investor's portfolio to create a covered call. The investor sells an out-of-the-money (OTM) call option that will benefit when the broad market falls or remains stagnant.

The trade gives very good results when the Implied Volatility Percentile (IVP) or the Implied Volatility Rank (IVR) is high.

Since the short call strategy has a very high loss potential, it is better for a professional trader to use it.

Key Takeaways

There are two simple ways to take a trade that will benefit from a downward movement of prices –  One, is to buy a Put, and the second, is to take a Short Call trade.

The seller of the call option gives the holder of the option the right to buy the underlying security at a specified price ― called the strike price ― before the option contract expires.

The seller, or writer, of the call option, receives a premium that the buyer of the call option pays for.

Short call strategy offers flexibility. The trader may set the strike price of the call option as high as he wishes, increasing the probability that the holder will not exercise the option.

The seller who takes the short call trade must deliver the underlying shares to the call buyer if the buyer exercises the option.

The trader who takes the short call strategy benefits from the option contract expiring worthless. This would happen if the price of the underlying security falls below the strike price.

The short call trader’s maximum profit is defined while his loss is unlimited.

Short Calls versus Long Put

Both the Short Call trade and Long Put trade benefit when the price of the underlying falls.

A long put options trade has a theoretical opportunity of unlimited gains, while the gains of a short call trader are defined as the amount of premium collected.

If the price of the underlying moves higher, the loss of a long put trade is defined as the amount paid for the premium. The short call trader has a theoretically unlimited loss opportunity.

If the underlying does nothing, that is, moves in a small range, the long put trade losses money, while the short call trade benefits from price decay.

Factors to consider while taking a Short Call trade

Impact of underlying price change

A short call trade normally moves in the opposite direction of the underlying. The relationship between the underlying and the call option is loosely dependent on the value of the options Greek called Delta. Thus, if an option has a Delta of 0.20, then for every 100 points move of the underlying, the option will move by 20 points.

Depending on the distance the trader expects the market to move, he can select the option strike price and pick the one offering the target return.

Impact of volatility

Option sellers generally prefer to take trades in a highly volatile environment as it offers them a higher premium to take home. The ideal time for taking a Short Call trade can be based on the Implied Volatility Rank (IVR) or Implied Volatility Percentile (IVP). A higher rank or percentile would offer the trader a good return on investment opportunity when volatility falls.

Impact of time

Time is an option seller's friend. With time the value of the option deteriorates, providing the trader a higher probability of winning even if the price does not fall. A short call trade can end up in profit even if the direction is wrong, but has failed to cross the breakeven point by the time of expiry.

Impact of stock price change

Call prices, generally, do not change rupee-for-rupee with changes in the price of the underlying. Rather, calls change in price based on their "delta". At-the-money (ATM) calls typically have deltas of approximately 50 percent. So, a Re 1 rise or fall in the stock price causes an at-the-money (ATM) call to rise or fall by Rs 0.50. In-the-money (ITM) calls tend to have deltas greater than 50 percent, but not greater than 100 percent. Out-of-the-money (OTM) calls tend to have deltas less than 50 percent, but not less than zero.

Impact of change in volatility

Volatility measures how much a stock price fluctuates in percentage terms. Volatility is a factor in option prices. As volatility rises, option prices tend to rise if other factors, such as stock price and time to expiration, remain constant. As a result, short-call positions tend to lose in a rising volatility scenario and benefit during decreasing volatility. Impact of time The time value portion of an option’s total price decreases as expiration approaches. This is known as time erosion. For short call trades, this is an important contributor to its success.

Conclusion

A short call trade offers limited profit opportunities but can result in unlimited loss. However, the trade, being a sell options trade, has a high probability of success. The short call trade is a building block and can be mixed with other option building blocks to form complex options strategies.