Bearish- Short Call

What Is the Short Call Strategy?

The short call strategy is an options trading strategy used by people who believe that an underlying asset will either go down in price or remain at the current level. The strategy derives its name from the fact that it essentially means to short-sell a call option that you do not own at the time.

The strategy is a bearish strategy for people with a high-risk tolerance as it has the potential for unlimited losses. Due to the high risk, this strategy is mostly used by traders with years of experience as they are more confident about placing their bets.

Short calls are also called naked calls as the seller in these cases does not own the underlying security at the time of selling the call option. The short call strategy involves taking a position to sell either an Out-of-The-Money Naked Call or an In-The-Money Naked Call based on your choice. The trader can earn a profit that is limited to the amount of premium if the underlying asset's price goes down. The loss can be unlimited for such a seller if the asset prices increase in the duration.

For example, if you are bearish about the overall economy of India, you will also be bearish about the NIFTY index. In this case, you can use the short call strategy and sell the call option of NIFTY. If the price of NIFTY falls in the duration of the contract, the call buyer will not exercise the option, and you will be profitable because you get to keep the premium that the buyer initially paid. On the other hand, if your prediction turns out to be wrong and the price of NIFTY rises instead, you stand to incur unlimited losses as the prices go up.

When to Use the Short Call Strategy?

The short call strategy should ideally be used when the trader is confident that the underlying asset will show downwards or sideways movement during the contract's duration. The strategy involves huge risks and is avoided by newer investors because of the potential for unlimited losses.

The seller stands to gain the maximum profit if the asset price remains the same or goes down at the end of the contract. If the trader is sure that the asset price will fall, the short call strategy is a relatively safe option to earn a profit in the form of the premium received.

Risk Profile

The short-call strategy has a 1/3rd chance of leaving you with a loss in your hands. To simplify, out of the three possible outcomes after you short sell a call option, two of the options (downward, sideways movement) are favourable to you as you will make a profit from the premium you received from the call buyer.

The only time you will be facing a loss in this type of options trading is when the underlying asset's price rises. The risk in case the price rises is very high as there is no limit to the losses you can face as a call options seller. However, the reward in short calls is limited to the total premium amount received from the call buyer.

Explanation With Example

To better understand the bearish short call strategy, let us take the help of an example where we assume the price of NIFTY to be 10000:

In this example, NIFTY is trading at 10000 in the stock market. You see a call option contract with a strike price of 10000 as well. If you are confident that NIFTY’s value will go down soon, you can short sell the call option of NIFTY at 10000 and receive an upfront credit of 20000 (premium received multiplied by lot size). This amount of 20000 is the maximum profit possible in this transaction if the buyer does not exercise the call option.

Three different situations can occur once you sell the NIFTY call option at 10000:

Premium Strategy Table:

Here is a premium strategy table that will help you understand the short-call strategy better in the case of different expiry prices.

Advantages of the Short Call Strategy

• The strategy is helpful in a bearish market.
• The strategy has a higher chance (2/3rd) of giving you a profit. The real-world probabilities can vary due to different variables.
• You have the choice to set the strike price of the call option as high as you wish. Setting the price higher will make the buyer less likely to exercise the option.

Disadvantages of the Short Call Strategy

• The maximum profit that you can earn from this strategy is limited to the premium amount paid by the buyer.
• The maximum loss is unlimited as the underlying asset’s value can increase to any extent.

Different Ways to Exit

There are multiple ways to exit the Short Call strategy without facing huge losses. However, you might not necessarily have these options in your situation.

• Waiting for the option's time duration to expire so you can retain your premium as profit.
• Buying back the option at a suitable price. Doing this minimizes your losses in the transaction.
• Buying a different call option at a strike price lower than your own. Doing this can help you in hedging your losses.

Risk Management Tip

To reduce the risk, you face when deploying the Short Call strategy, we advise you to use the Stop Loss feature. The Stop Loss feature can save you from facing huge sales losses.

Summary

The Short Call strategy is a relatively safe way to generate a steady income when the markets show a downward or sideways trend. This strategy is suitable for seasoned players in the options market who are experienced with the market's movements and have a higher risk capacity than other traders if the security prices rise. Newer traders should follow this guide and be cautious when short-selling call options because the market's volatility and trends can be difficult to predict without experience and knowledge.