Short Call Strategy Explained - Online Option Trading
20 Jun 2017
Nilesh Jain
Short Call Strategy:
What is Short Call strategy?
A Short Call means selling of a call option where you are obliged to
buy the underlying asset at a fixed price in the future. This strategy has limited profit
potential if the stock trades below the strike price sold and it is exposed to higher risk
if the stock goes up above the strike price sold.
When to initiate a Short Call?
A Short Call is best used when you expect the underlying asset to fall
moderately. It would still benefit if the underlying asset remains at the same level,
because the time decay factor will always be in your favour as the time value of Call
option will reduce over a period of time as you reach near to expiry. This is a good
strategy to use because it gives you upfront credit, which will help you to somewhat
offset the margin. But by initiating this position you are exposed to potentially
unlimited losses if underlying assets goes dramatically high in price.
How to construct a Short Call?
A Short Call can be created by selling 1 ITM/ATM/OTM call of the same
underlying asset with the same expiry. Strike price can be customized as per the
convenience of the trader.
Strategy
|
Short Call Option
|
Market Outlook
|
Neutral to Bearish
|
Motive
|
Earn income from selling premium
|
Breakeven at expiry
|
Strike price + Premium received
|
Risk
|
Unlimited
|
Reward
|
Limited to premium received
|
Margin required
|
Yes
|
Probability
|
66.67%
|
Let’s try to understand with an Example:
NIFTY Current market Price
|
9600
|
Sell ATM Call (Strike Price)
|
9600
|
Premium Received
|
110
|
BEP (Rs.)
|
9710
|
Lot Size
|
75
|
Suppose Nifty is trading at Rs 9600. A Call option contract with a
strike price of 9600 is trading at Rs 110. If you expect that the price of Nifty will fall
marginally in the coming weeks, then you can sell 9600 strike and receive upfront premium
of Rs 8,250 (110*75). This transaction will result in net credit because you will receive
money in your broking account for writing the Call option. This will be the maximum amount
that you will gain if the option expires worthless.
So, as per expectation, if Nifty falls or remains at 9600 by
expiration, therefore the option will expire worthless. You will not have any further
liability and amount of Rs 8,250 (110*75) will be your profit. The probability of making
money is 66.67% as you can profit in two scenarios: 1) when price of underlying asset
falls. 2) When price stays at same level.
Loss will only occur in one scenario i.e. when the underlying asset
moves above the strike price sold.
Following is the payoff schedule assuming different scenarios of
expiry. For the ease of understanding, we did not take into account commission charges and
Margin.
On Expiry Nifty closes at
|
Net Payoff from Sell Buy
(Rs.)
|
9300
|
110
|
9400
|
110
|
9500
|
110
|
9600
|
110
|
9700
|
10
|
9710
|
0
|
9800
|
-90
|
9900
|
-190
|
10000
|
-290
|
10100
|
-390
|
10200
|
-490
|
Payoff Diagram:
Impact of Options Greeks:
Delta: Short Call will have a negative Delta, which indicates any rise
in price will have a negative impact on profitability.
Vega: Short Call has a negative Vega. Therefore, one should initiate
Short Call when the volatility is high and expects it to decline.
Theta: Short Call will benefit from Theta if it moves steadily and
expires at or below strike sold.
Gamma: This strategy will have a short Gamma position, which indicates
any significant upside movement, will lead to unlimited loss.
How to manage Risk?
A Short Call is exposed to unlimited risk; it is advisable not to carry
overnight positions. Also, one should always strictly adhere to Stop Loss in order to
restrict losses.
Analysis:
A Short Call strategy can help in generating regular income in a falling or sideways
market but it does carry significant risk and it is not suitable for beginner traders.
It’s also not a good strategy to use if you expect underlying assets to fall quickly
in a short period of time; instead one should try Long Put strategy.