What is short call: Meaning, benefits, and risks

Understanding strategies like the “short call” is crucial if you’re considering starting options trading. The term short call might sound complex but is relatively straightforward.

In simple terms, a short call is a move in options trading where a trader sells a call option, essentially predicting an anticipated drop in the value of the underlying asset.

It’s like saying, “I don’t think the value of this stock is going to rise, so I’ll sell a contract at a specific price.” It is a bearish strategy, where traders expect a decline and position themselves accordingly.

Join us as we break down the short call meaning and explore why traders use this strategy. 

What is the short call option?

A short call option is a financial contract that gives the holder the right, but not the obligation, to sell a specific asset (like stocks) at a predetermined price (strike price) before a certain date (expiration date).

If you are the one selling or “writing” the call option, you are taking a short call position. This means you are obligated to sell the asset if the option buyer decides to exercise their right.

To put it even more straightforwardly, it’s like agreeing to sell something at a fixed price in the future, but only if the buyer wants to go through with the purchase.

Now let’s understand it better with the short call option example:

Mr. Rahul believes the stock market (Sensex) is going to go down. To take advantage of this, he does something called “selling a call option.” This means he offers someone else the chance to buy the contract of underlying stocks from him at a specific price (₹1,000) in the future.

In a short call, Mr. Rahul sells a call option and receives a premium (say ₹140). The strike price is set at ₹1000. Here’s what can happen in 3 cases:

1. Stock price drops to ₹800: The buyer won’t execute the contract for ₹1000 when it’s cheaper in the market. Rahul keeps the ₹140 as profit.
2. Stock price stays at ₹1000: There’s no advantage for the buyer to exercise the option. Rahul again keeps the ₹140.
3. Stock price rises to ₹1200: The buyer will buy the underlying stock contract at the lower strike price of ₹1000. Rahul has to sell it for less than its market value and ends up with a ₹60 loss (₹1200 – ₹1000 – ₹140).

How and when to execute a short call?

A Short Call strategy, also known as a Naked Call, is a sophisticated option trading method. It involves selling a call option when you don’t own the underlying asset. 

This approach is primarily used by traders who have a bearish outlook on a stock or index, expecting its price to fall shortly, which is just the reverse of a long call and short put strategy where you have a bullish outlook.

Conditions for a short call

The Short Call strategy is most effective under certain market conditions:

1. Moderate price decline expected: Ideal when you anticipate a slight drop in the underlying asset’s price.
2. Static price scenario: Also beneficial if the asset’s price remains unchanged, leveraging the time decay of options.

How to execute a short call?

Here’s a step-by-step guide for your most searched question on how to short call option:

• Market analysis: Begin with a thorough analysis of the market. Understand the trends and factors that could influence your interest in the underlying stock or index.
• Option selection: Choose the type of call option by selecting strike price: ITM, ATM, or OTM.
  • In-The-Money (ITM): If you expect a significant decline.
  • At-The-Money (ATM) or Out-Of-The-Money (OTM): For moderate or minimal decline expectations.
• Example for clarity:
  • Imagine you’re analyzing the NIFTY index, currently at 21,400 points.
  • If bearish, you might sell an ITM call option with a strike price of 21,200.
  • This means you’re betting that NIFTY will not rise above 21,200 points by the option’s expiration.
• Premium collection: Upon selling the call option, you collect the premium, which is your potential profit.
• Monitoring and adjustment:
  • Keep a close eye on market movements.
  • Be prepared to adjust your position if the market goes against your prediction.
• Risk management:
  • Set a stop-loss level to minimize potential losses.
  • Be aware of the potential for unlimited losses if the market moves against you.
• Regulatory compliance: Understand and comply with the margin requirements set by Indian trading exchanges for such trades.
• Closing the position:
  • If the market behaves as expected, and the option is likely to expire worthless, you keep the premium.
  • If the market moves unfavourably, consider closing the position to limit losses.

Short Call strategy in the Indian market is not just about executing trades but about doing so with a clear understanding of market dynamics, risk management, and regulatory compliance.

Rewards vs risks of trading short calls

Here are some benefits and drawbacks of trading short calls:

Rewards of short calls

Let’s break down the rewards of short calls:

• Income generation: By selling a call option, you receive a premium (payment) from the buyer. This is like getting paid upfront for the obligation you take on.
• Time decay: As time passes, the value of options tends to decrease. If the underlying stock price doesn’t go above the strike price, the call option’s value may decrease, allowing you to keep the premium you received.

Risks of short calls

Now, let’s delve into the risks associated with short calls:

• Unlimited Risk: The main risk of short calls is that your potential losses are theoretically unlimited. If the underlying stock price rises significantly, you might have to sell the contract at a lower strike price, resulting in a loss.
• Opportunity Cost: If the underlying stock price rises significantly, you miss out on potential profits since you’re obligated to sell at a lower price.

Exercise caution, especially if you’re a beginner, it’s vital to use only a small portion of your capital for such strategies. Stay informed about market trends and conditions, as these greatly impact the success of a Short Call.

Popular strategies in short calls

Short calls can be used for several reasons, such as generating income or hedging against an existing long position. Here are some key strategies when using short calls:

1. Covered call strategy

In the covered call strategy, you already own a stock and sell call options for it. This helps protect against potential losses in the underlying stock’s value. 

By selling calls, you receive premiums, providing some downside cushion. If the underlying stock price rises above the call’s strike price, you may have to sell your contract but still keep the premium. 

It’s a strategy for earning income and managing risk, commonly used when you have a neutral or slightly bullish outlook on the underlying stock’s performance.

2. Uncovered (naked) call strategy

The Naked Call strategy involves selling call options without owning the underlying stock. It’s a risky move, as the seller faces unlimited potential losses if the underlying stock price rises significantly. 

The hope is that the underlying stock remains stable or falls, allowing the seller to keep the premium received for selling the calls. 

This strategy requires a bearish outlook on the stock, and careful risk management is essential to mitigate potential losses in case the market moves against the seller.

Conclusion

Short Call is a trading strategy where you sell a call option, expecting the underlying stock’s price to decrease. It’s a bearish approach that involves potential risks and rewards.

Remember, financial markets can be unpredictable, so thorough research and understanding are crucial. For those keen on mastering trading, stay tuned to StockGro blogs.

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