Sell call (Short Call)
Short call positions
Selling, or writing a call, said to be a short call position, creates the obligation to sell a stock at a predetermined strike price. This contract is sold for a premium, and if the stock does not reach the strike price by expiration, the contract will expire worthless, therefore the writer will keep the premium as a profit. However, if the stock does rise beyond the strike price, the writer will be obligated to sell the stock at that strike.
If the call writer does not own the underlying stock, a short position on the stock will be created, this is called a naked call. If the writer does own the underlying stock, the position is called a covered call, and that stock may be sold at the strike price.
Consider a naked call example
Sell SINA 1 month 110 at 2.5
In this case, SINA is trading at 102, a trader Shawn believes SINA will remain below $110 one month from now, he sells 1 call for a premium of $2.5 opening a short position in that series.
Figure 1 shows the expected pay out of such a position at expiry. The higher the stock is above the strike price, the greater the intrinsic value of the call, as a seller you want the call to have little or no intrinsic value at expiration. If the stock is below 112.50 at expiration, Shawn will have a profit. This is the break even price, it is the strike price plus the premium.
Stock prices may rise indefinitely, therefore selling a naked call has unlimited risk of loss. Many brokers might refuse naked calls as it will require a high level of approval, and high margin requirements.
Note here that since the maximum profit to be made is the premium, if Shawn believed the stock’s value would decline, he would have used a different strategy.
This is a difference between buying a call and selling a call: When writing a naked call, the loss is unlimited, and the profit is limited. When buying a call there is unlimited profit, and limited loss.
Let’s take a look at a covered call example
Buy 100 shares of SINA at $102,
Sell 1 SINA 110 call at $2.50
Traders might not like the words unlimited and risk standing next to each other. Traders may use a spread to avoid the unlimited aspect of selling calls. With spreads, there are now different risks, and the option’s risks may be limited but there are new risks associated to the value of the stock it self.
A common call selling spread for a neutral to slightly bullish forecast is the covered call.
After reviewing all the data and information he could get on SINA, our trader Shawn believes it will stay between 99.5 and 112.5, over the next month. Shawn buys 100 shares of SINA at $102, and sells one SINA 1 month call at 2.50.
The implications of such a spread now expand beyond the risk of selling a naked call option:
- Shawn must be happy to hold SINA at $102
- He must also be ready to sell SINA at $110.
Figure 2 shows the outcome at maturity of a covered call spread. The dotted line represents owning the stock only, you can see there is a limited downside protection from the covered call’s premium. This strategy outperforms over holding the stock outright, below the strike.
On a side note this at expiration diagram looks a lot like a short put position.
Example scenarios where one might want to hold a covered call position include:
- Having bought the stock near the strike price of the call contract, and the stock’s price fell below the strike price for a short period of time, but we nonetheless would like to sell this stock. Using a covered call we can reap an extra profit if the volatility of the underlying is not great. Even if it does get above strike price, we had the intention of selling it.
- Another reason might be to get a premium on a stock that is below the strike price, and is not expected to get above it.
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