Knowledge Base

What is a Short Call?

in Trading Strategies
Tags: short calltrading strategy

Sometimes, financial markets go through a period of doom and gloom. There are no assets that promise assured money for an investor during such times. His only hope, then, of making money is by shorting assets—selling them now and buying them later, when prices fall. The short call strategy – an Options-based trade strategy – can help make profits by short-selling.

Here is all you need to know about the short call strategy

What is a short call strategy

A Call Option gives its buyer the right, but not the compulsion, to buy an asset at a pre-defined price, on a future date. It is the opposite of a Put Option, which allows him to sell the asset in a similar fashion. A short call strategy involves the sale (shorting) of a Call Option, which gives its buyer the right to buy an asset at a fixed price on a future date. In lieu of the sale, the seller gets a price called premium.

Application of a short call strategy

A short call strategy is typically used by investors who have a negative (bearish) outlook on the asset. By selling the Call, they provide the Option buyer the right to buy the asset in the future. However, the counterparty buyer is unlikely to use the Option because when the price falls, he will be able to buy the asset cheaper in the open market than by using the Option. For the seller of the option, the strategy provides an opportunity to earn the premium by selling a right that most likely will not be used. Of course, there is the risk that if his outlook turns out to be false, he could incur unlimited losses.

Payoff of the short call when the asset depreciates

Let’s look at an example to see how a short call works.

Consider a stock that is currently priced at Rs 40 and is expected to depreciate. You short a Call Option on 100 shares of the stock with a strike price of Rs 40 itself and a maturity of three months. For this, you receive a premium of Rs 2 per share (Rs 200 in all). Now, suppose the stock falls to Rs 25 in three months. The buyer of the call will not exercise it because exercising it would mean buying the stock at the original price of Rs 40, instead of the lower current price of Rs 25. The seller, on the other hand, has already earned a premium of Rs 200 by selling the Call.

Payoff of the short call when the asset appreciates

Now, suppose the stock appreciates to Rs 52 after three months instead of depreciating. The Call buyer will be able to buy the stock at the original price of Rs 40 instead of the new, higher price by exercising the Option. This will earn him a profit of Rs 12 per share (Rs 1200 in all). For you – the seller of the call, this would mean an overall loss of Rs 1200. Adjusting for the premium you received for selling the Option, the net loss is Rs 1000. The loss would have been higher if the stock were to appreciate more. This is why shorting Calls is a dangerous maneuver and should be done with extreme caution.

Benefits of a Short Call strategy

The strategy is risky, but it also has its own benefits.

You can use two other strategies to benefit from a price decline—the Buy Put strategy and a Short Selling strategy. The Buy Put strategy allows you to sell the asset at the present price when it declines in the future. The other strategy allows you to borrow and sell an asset now and buy it back later, when its price falls.

The Short Call strategy is advantageous over both these strategies. The Buy Put strategy leads to a payment of the premium because you are purchasing the put option. In contrast, the Short Call strategy leads to an inflow of the premium payment.

In case of Short Selling, you are required to buy the asset in the end, to complete the trade, by paying its full price. In contrast, in a Short Call, you receive a premium and if the asset appreciates, you only lose the difference between the market price and the strike price.