Short call

What Is a Short Call?

A short call is an options strategy that involves selling a call option contract. Within the broader category of options trading, selling a short call means an investor believes the price of an underlying asset will either stay below a certain strike price or decline by the expiration date of the contract. The seller receives a premium from the buyer for taking on the obligation to sell the underlying asset if its price rises above the strike price.

History and Origin

The concept of options has roots dating back to ancient Greece, with modern options contracts gaining structure over centuries. However, the formalization and widespread adoption of exchange-traded options, including the short call, are largely tied to the establishment of the Chicago Board Options Exchange (CBOE) in 1973. Prior to this, options were primarily traded over-the-counter (OTC) with varying terms and limited liquidity. The CBOE introduced standardized options contracts, centralizing the market and significantly increasing transparency and accessibility for investors⁷. This standardization paved the way for options strategies like the short call to become a common tool in financial markets.

Key Takeaways

• A short call involves selling a call option, betting on the underlying asset's price staying flat or decreasing.
• The maximum profit for a short call is limited to the premium received.
• The potential loss for a short call can be unlimited if the underlying asset's price rises significantly above the strike price, particularly for a naked option.
• Investors often use short calls to generate income from the premium or to express a bearish to neutral outlook on an asset.
• Selling short calls requires a margin account to cover potential losses, or owning the underlying shares in the case of a covered call.

Formula and Calculation

The profit or loss for a short call position depends on the underlying asset's price at expiration relative to the strike price and the premium received.

Let:

• (S_t) = Price of the underlying asset at expiration
• (K) = Strike price of the call option
• (P) = Premium received per share (in dollars)

The profit/loss is calculated as follows:

The break-even point for a short call is the strike price plus the premium received:

[
\text{Break-even Price} = K + P
]

This formula indicates the price at which the seller neither profits nor loses money.

Interpreting the Short Call

Interpreting a short call involves understanding the seller's market outlook and the inherent risk-reward profile. When an investor sells a short call, they are typically expressing a neutral to bearish view on the underlying asset. They anticipate that the asset's price will either remain below the strike price or decline. The profit generated from a short call is capped at the premium received, which is earned if the option expires worthless (i.e., out-of-the-money). However, the potential for loss is theoretically unlimited if the underlying asset's price unexpectedly surges. Therefore, a short call is often used by investors seeking to generate income in stagnant or declining markets, but it requires careful risk management due to the skewed payoff structure. Understanding Option Greeks can help in interpreting the sensitivity of the option's price to various factors like time decay and volatility changes.

Hypothetical Example

Consider an investor who sells a short call on XYZ stock with the following details:

• Current Stock Price: $50 per share
• Strike Price (K): $55
• Premium (P): $2.00 per share (or $200 for a standard 100-share options contract)
• Expiration Date: One month from now

Scenario 1: XYZ stock closes at $50 or below at expiration.
If XYZ stock is at $50 or any price below the $55 strike price at expiration, the call option expires worthless. The buyer will not exercise the option because they can buy shares in the open market for less than $55. The investor keeps the full $200 premium received, which is their maximum profit.

Scenario 2: XYZ stock closes at $56 at expiration.
In this case, the stock price ($56) is above the $55 strike price. The option is in-the-money, and the buyer will likely exercise it. The investor is obligated to sell 100 shares of XYZ at $55 each.

• Premium received: $200
• Loss from assignment: (( $56 - $55 ) \times 100 \text{ shares} = $100)
• Net Profit = Premium Received - Loss from Assignment = ($200 - $100 = $100)

Scenario 3: XYZ stock closes at $60 at expiration.
Here, the stock price ($60) is significantly above the $55 strike price.

• Premium received: $200
• Loss from assignment: (( $60 - $55 ) \times 100 \text{ shares} = $500)
• Net Loss = Premium Received - Loss from Assignment = ($200 - $500 = -$300)

The break-even point for this short call is ( $55 + $2.00 = $57 ). If the stock closes exactly at $57, the investor breaks even. Any price above $57 results in a loss for the short call seller.

Practical Applications

The short call is a versatile tool in options trading and finds several practical applications for investors with specific market outlooks. One primary use is generating income through the collection of premium. When an investor believes an underlying asset will remain stagnant or decline, selling a short call allows them to collect the premium as profit if the option expires out-of-the-money.

Another common application is in forming part of more complex options strategies, such as a credit spread or iron condor, to define risk. When a short call is combined with ownership of the underlying shares, it becomes a covered call, a strategy often employed by long-term investors to generate additional income on their existing stock holdings while limiting upside potential.

The growth of the options market, which saw volumes soar in recent years, reflects the increasing use of these strategies by both retail and institutional investors⁵, ⁶. For example, the U.S. options market has seen record volumes, indicating a widespread adoption of various options strategies for income generation, hedging, and speculation³, ⁴. This market activity demonstrates the real-world application of short calls in a dynamic financial environment [Reuters].

Limitations and Criticisms

While potentially profitable, the short call strategy carries significant limitations and risks, particularly when sold as a naked option (without owning the underlying shares). The primary criticism is the unlimited potential for loss. If the price of the underlying asset rises significantly above the strike price, the seller's losses can mount rapidly, far exceeding the initial premium received [Forbes Advisor]. This contrasts sharply with long options positions, where the maximum loss is limited to the premium paid.

To mitigate this risk, short call sellers are typically required to maintain a margin account with their broker, providing collateral to cover potential losses. Brokers often set strict leverage limits and may issue margin calls if the position moves adversely. Furthermore, unlike buying a put option, which provides a direct hedge against a price decline, a short call does not offer protection against upward price movements. The Securities and Exchange Commission (SEC) actively regulates options trading to protect investors, highlighting the inherent complexities and risks involved in these instruments¹, ². Therefore, investors considering short calls must fully understand these limitations and their potential financial exposure.

Short Call vs. Long Call

A short call and a long call represent opposing positions in options trading, reflecting entirely different market outlooks and risk-reward profiles.

The confusion often arises because both involve call options. However, a short call is undertaken by a seller who believes the underlying asset will not rise above the strike price, aiming to profit from the premium. Conversely, a long call is taken by a buyer who expects the underlying asset's price to increase significantly, aiming to profit from the appreciation of the option's value or by exercising the right to buy the shares at a lower strike price.

FAQs

What does "short" mean in options trading?

In options trading, "short" refers to selling an options contract. When you go short, you are obligated to fulfill the terms of the contract if it is exercised by the buyer.

Why would an investor sell a short call?

An investor would sell a short call primarily to generate income from the premium received. This strategy is typically used when the investor has a neutral to bearish outlook on the underlying asset, expecting its price to stay below the strike price or decline.

What is the maximum profit for a short call?

The maximum profit for a short call is limited to the premium collected when selling the call option. This profit is realized if the option expires worthless, meaning the underlying asset's price is at or below the strike price at expiration.

What are the risks of a short call?

The main risk of a short call, especially a naked option, is theoretically unlimited loss. If the underlying asset's price rises significantly above the strike price, the seller's obligation to sell the shares at the strike price can result in substantial losses.