Sharekhan Blog

What is Short Call?

  • Apr 17, 2024

This transaction yields an upfront premium but commits them to sell the asset at a predetermined price, the strike price if the option is exercised early. Essentially, the call option seller wagers on the asset's price declining or remaining below the strike price until expiration.

Mechanics of Short Calls

1. Option Contract

The trader engages in the sale of call option pacts, with each pact granting the entitlement to procure 100 shares of the underlying asset at a designated strike price.

2. Premium

A multitude of factors, encompassing the volatility of the underlying asset, the duration until expiry, and the variance between its prevailing market value and strike price, dictate a reward. It constitutes an initial remittance symbolising the utmost potential gain for the seller of a call option. The seller receives this premium from their buyer.

How Does a Short Call Work?

It is important to understand the short call meaning before executing a short call strategy. The trader profits in the following scenarios:

1. Option Expires Worthless

Should the underlying asset's price persist below the strike price until option expiration, this particular option will likely expire without value. In such instances, call option sellers can retain their initially received premium as profit, all without necessitating delivery of said underlying assets.

2. Limited Profit Potential

A short call's maximum profit potential is limited to the upfront received premium. This scenario manifests upon option expiration as worthless, enabling the seller to completely retain the entire premium.

3. Decline in Asset Price

The seller may choose to keep the premium as profit even if the option is not permitted to expire if the value of the underlying asset falls or is unable to rise above the strike price. Alternatively, the seller may choose to buy back the call option at a reduced cost or allow it to expire worthless.

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Risks of Short Calls

While short calls offer potential profit opportunities, they also come with inherent risks. It is absolutely essential to know about these risks before taking the final investment decision. Here, we have listed the most important risks associated with short calls.

1. Unlimited Losses

When a trader sells a call option, they face the potential for unlimited losses if the price of an underlying asset escalates significantly beyond the strike price. This is in contrast to buying a call option, where one's maximum loss remains limited, merely equating to its premium paid.

2. Obligation to Sell

Should the underlying asset's price surpass the strike price, then an obligation falls upon the call option seller to sell that asset at a pre-arranged cost even if market prices escalate substantially beyond this agreed-upon value. Such circumstances may provoke significant losses should market figures outpace your strike margin by a considerable measure.

3. Margin Requirements

When brokers sell call options, they may demand that traders maintain a specific margin level to safeguard against potential losses. If traders fail to meet these margin requirements, it could trigger the forced liquidation of their positions.

Considerations for Short Call Traders

Before implementing the short call option, traders should consider the following:

1. Market Outlook

Neutral to bearish market outlooks best suit short calls, where the trader predicts a decline or stagnation in underlying asset prices.

2. Risk Management

To offset potential losses, individuals can employ risk mitigation methodologies like establishing stop-loss orders and deploying safeguarding tactics such as procuring additional out-of-the-money call options.

3. Understanding Volatility

Changes in volatility can significantly impact option prices. Therefore, traders must evaluate the underlying asset's implied volatility and its potential influence on these prices.

4. Time Decay

The value of short calls decreases as they approach expiration, benefiting from time decay. Yet, traders must remain aware of how time decay affects their positions.

Long and Short Call

In the context of long and short call, a long call in options trading entails the purchase of a call option. This grants the buyer an intriguing right to procure an underlying asset at a prearranged price within a stipulated time period. Typically, traders who predict bullish market conditions use this strategy. They expect that prices for said underlying assets will ascend.

Conversely, engaging in a short call involves an intriguing paradox. It is the act of selling a call option without possessing the underlying asset. Depending on their outlook and risk tolerance, both long and short-call strategies provide unique opportunities for traders to capitalise on market movements.

Know What is Call Option?

Conclusion

Short calls offer profit potential in neutral to bearish markets. Traders sell call options to collect premiums, managing risks with adept techniques. However, it is important to remember that thorough research, analysis, and disciplined execution are crucial for success.

Team Sharekhan
by Team Sharekhan

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