Short Call Option Strategy: A complete guide for beginners

What is a Short Call option Strategy?

Selling a naked call option, known as a short call, is a leveraged alternative to short selling stock but without any safety net if the stock decides to skyrocket. You’re essentially flying without a parachute here.

A short call (or selling a call) is an options strategy where you sell (or “write”) a call option, giving the buyer the right to purchase the underlying asset from you at a specified price (the strike price) by a certain date (the expiration date). In return, you receive a premium upfront. 

Each short call contract equals selling 50 shares of stock, and you need margin to protect against massive price increases in the underlying asset. Essentially, you’re putting your neck on the line with nothing but a flimsy hope that the stock won’t shoot up.

When to use a Short Call?

This strategy is typically used when you have a bearish outlook on the asset and expect its price to stay below the strike price.

The closer the strike price is to the current stock price, the more credit you have in your pocket. It’s like betting on your neighbor’s cricket team losing—risky but potentially rewarding.

How to set up a short call?

You start a short call position by writing (selling) a call option contract. The option chain shows you all the strike prices and expiration dates. The money you get from selling the call is called the premium. The value of the premium depends on the strike price, time until expiration, and volatility.

Payoff diagram of a Short Call

The payoff diagram for a short call is simple: Your maximum profit is the premium you receive when selling the call, but your risk is unlimited if the stock price rises. It’s like betting against a star player in a cricket match—potentially disastrous.

Example: Selling a ₹1000 call for ₹50 means your maximum profit is ₹50. If the stock price goes above ₹1050, you start losing money.

Exiting a short call

You can exit a short call position anytime before expiration with a buy-to-close (BTC) order. If you buy it back for less than you sold it, you’ve made a profit. If more, you’re facing a loss.

If the buyer exercises the call, you must sell 100 shares at the strike price. If the option is in-the-money (ITM) at expiration, it’s automatically assigned. Out-of-the-money (OTM) options expire worthless, and you keep the entire premium.

Time decay impact on a Short Call Strategy

Time decay, or theta, works in favor of short call sellers. As the expiration date approaches, the option’s value decreases, benefiting you as the seller.

Implied volatility impact on a Short Call Strategy

Implied volatility is the market’s expectation of future price swings. Higher volatility means higher option prices because everyone’s bracing for a bumpy ride. If volatility drops, the option’s price drops, allowing you to buy it back cheaper. Lower volatility means you win, so a calm market is beneficial.

Adjusting a short call into a bear call spread

You can manage your short call option to reduce potential losses by converting it into a bear call spread.

Original setup

• Position: Sold a ₹1000 call for ₹50.

Adjustment

• Action: Buy a call option at a higher strike price (e.g., ₹1100 call for ₹20).
• Benefit: Lowers your cost and break-even point.
• Drawback: Limits your maximum profit.

Calculations

• Initial premium received: ₹50
• Premium paid for the bought call: ₹20
• Net premium received: ₹50 – ₹20 = ₹30
• Maximum loss: Difference in strike prices – Net premium received
  • (₹1100 – ₹1000) – ₹30 = ₹100 – ₹30 = ₹70
• Maximum profit: ₹30 (net premium received)
• Break-even point: ₹1000 + ₹30 = ₹1030

Rolling a short call

You can extend the trade by rolling the short call option. This means buying back your current option and selling a new one with a later expiration date.

Example

• Initial position: Sold a ₹1000 call expiring in March for ₹50.
• Adjustment:
  • Bought back the March ₹1000 call before expiry for ₹70 (net loss of ₹20).
  • Sold an April ₹1000 call for ₹90.

Calculations

• Net loss on original position: ₹50 – ₹70 = -₹20
• Net premium received after rolling: ₹90 – ₹20 = ₹70

Summary

• Net premium received after rolling: ₹70
• Break-even point: ₹1000 + ₹70 = ₹1070

Hedging a short call

To hedge a short call, an investor may sell a put with the same strike price and expiration date, creating a short straddle. This adds additional credit and extends the break-even price above and below the centered strike price, equal to the amount of premium collected.

Example

• Initial position: Sold a ₹1000 call for ₹50.
• New adjustment: Sold a ₹1000 put for ₹50.

Calculations

• Total premium received: ₹50 (call) + ₹50 (put) = ₹100
• Break-even points:
  • Upper break-even: ₹1000 + ₹100 = ₹1100
  • Lower break-even: ₹1000 – ₹100 = ₹900

Summary

• Total premium received: ₹100
• Max profit: ₹100
• Break-even range: ₹900 to ₹1100

Synthetic long put

You can create a synthetic long put by combining a short stock position with a long call option at the same strike price.

Example

• Action: Short ₹1000 worth of stock and buy a ₹1000 call option for ₹50.
• Result:
  • Downside risk is limited to the call option’s strike price.
  • Profit potential is limited to the difference between the sale price of the short stock position and the call option premium paid.

Bottom line

A short call strategy offers the potential for generating income in a flat or bearish market, but it comes with substantial risk due to unlimited loss potential. Effective risk management, including monitoring the market and setting stop-loss orders, is crucial for mitigating these risks.