What is a Short Call
A short call is an options strategy in which a trader takes a bearish opinion of a stock, bond or futures position. It gives the holder of the option the right, but not the obligation, to sell a security.
A call option is an agreement that gives the buyer the right to purchase a stock, bond, commodity or other instrument at a set price, within a specific window of time.
BREAKING DOWN Short Call
A short call strategy is one of two simple ways options take bearish positions. It involves selling calls, as opposed to buying puts. The latter strategy gives the holder the right to sell a security at a certain price within a specific time frame.
If the price falls, a short call strategy profits. If the price rises, there’s unlimited exposure during the length of time the option is viable, which is known as a naked short call. To limit losses, some traders will exercise a short call while owning the underlying security, which is known as a covered call.
Say Liquid Trading Co. decides to sell calls on shares of Humbucker Holdings to Paper Trading Co. The stock is trading near $100 a share and is in a strong uptrend. However, the group believes Humbucker is overvalued, and based on a combination of fundamental and technical reasons, they believe it eventually will fall to $50 a share. Liquid agrees to sell 100 calls at $110 a share. This gives Paper the right to purchase Humbucker shares at that specific price.
Selling the call option allows Liquid to collect a premium upfront; that is, Paper pays liquid $11,000 (100 * $110). If the stock heads lower over time, as Liquid thinks it will, Liquid profits on the difference between what they received and the price of the stock. Say it does reach $50. Then Liquid reaps a profit of $6,000 ($11,000 - $5000).
Things can go awry, however, if Humbucker shares continue to climb, creating limitless risk for Liquid. For example, say the shares continue their uptrend and go to $200 within a few months. If Liquid executes a naked call, Paper can execute the option and purchase stock worth $20,000 for $11,000, resulting in a $9,000 trading loss for Liquid.
If the stock were to rise to $350 before the option expires, Paper could purchase stock worth $35,000 for the same $11,000, resulting in a $24,000 loss for Liquid.
How a Short Call Differs From a Long Put
Buying a put option also is bearish, but this strategy works differently. Say Liquid wants to buy $110 Humbucker puts instead. To do so, they must put up the $11,000 ($110 * 100) in cash for the option. Liquid now has the right to force Paper, who is on the other side of the deal, to buy stock at this price. Unlike the short call, the most Liquid can lose is $11,000, or the total price of the option.