What is a Short Call?

The decision to purchase or sell is fundamentally driven by the expected price movement. Typically, rational traders purchase a security when the price is expected to increase whereas it is sold if the price is expected to fall.

Traders who expect a price reduction but do not own underlying shares fail to benefit from a fall in prices. In such a case, a short call proves to be an ideal solution.

Short Call Option: Meaning and Definition

A short call is an options trading strategy for bearish traders. Essentially, short-call traders bet on a share price fall and benefit from a fall in prices.

A short call strategy involves selling a call option. The seller of the call option is obligated to sell the underlying security by a specified future date (expiry date) for a pre-specified price (strike price) for a premium. The buyer of the call option has the right but not the obligation to exercise the option. The seller is required to fulfill his obligations if the buyer executes the option.

On expiry, if the stock price of the underlying security is greater than the strike price of the option then the holder will exercise the option. The seller is obligated to sell the security at the strike price which is lower than the market price of the security. The difference between strike and market price is the profit for the holder.

On the contrary, if the price of the underlying security is lower than the strike price of the option then the seller will not exercise the option and it will expire worthlessly. In this case, the seller of the option earns a profit to the extent of the premium paid by the buyer of the option.

The primary advantage of the short call option is its flexibility. A trader has the right to set the strike price of the call option as high as possible, reducing the probability of the holder exercising the option. The risk involved in the short-call strategy is unlimited since the price of the underlying may increase indefinitely. The profit potential is limited to the premium earned from writing the call option.

Ideally, a short call option is best suited when the price of the underlying security is expected to fall drastically. It is efficient even if the price of the security falls moderately since the time value favors the writer of the call option. The time value of a call option reduces over time and is zero at the expiry of the option.

How to construct a Short Call?

Constructing a short-call option is relatively easy. It involves selling an in-the-money, at-the-money, and out-of-the-money call option with the same expiry dates. You can customize the strike price of these options based on the risk appetite and convenience of the trader.

The purpose of a short call is to earn a profit from the premium paid by the buyer of the call option. The breakeven point at the expiry of the call option is the strike price plus the premium earned. The probability of profit is two-thirds in case the price of the underlying remains stable or falls. The trader will incur a loss only when the price of the underlying increases.

Real-World Example of a Short Call

Suppose the share price of HDFC Bank is trading at INR 1600. You expect the price to correct shortly. You decide to write a call option with a strike price of INR 1500 at a premium of INR 50. The lot size is 100 shares. You earn an upfront premium of INR 5000 from writing the option. INR 5000 is also the maximum profit potential from the trade.

Now, if the market price of HDFC Bank on expiry is INR 1470 then the holder will not exercise the option. The reason is, that HDFC shares are available in the market for INR 1470 versus the contracted strike price of INR 1500. The option expires worthless and you earn INR 5000.

If the market price of HDFC Bank on expiry is INR 1550 then the holder will exercise the option. You make a loss of INR 50 per share i.e. INR 5000 for 100 shares. The loss is offset by the premium earned of INR 5000. If the market price of HDFC Bank falls below INR 1550 then you will incur a loss.

Conclusion

While a short-call strategy aids in generating regular income in a bearish or sideways market, it carries a significant amount of risk. Alternative strategies such as Long Put must also be evaluated thoroughly to make an informed decision.