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The Short Call Strategy

Short Call

DESCRIPTION

The Short Call is considered as one of the basic strategies since it is easy to execute. However, shorting a call (without a cover) is a risky strategy so, like most experts, I always categorize it as an advanced strategy. Shorting a call exposes us to unlimited risk if the underlying stock rises quickly.

A call is an option to buy and therefore if we are shorting it (selling to open), we are expecting the market to go down.

ITM

In-the-money

Stock price < call strike price

ATM

At-the money

Stock price = call strike price

OTM

Out-of-the-money

Stock price > call strike price

STEPS TO TRADING A SHORT CALL

  1. Sell the call option

Remember:

    1. Each contract gives you the option to buy the number of the underlying asset as per the lot size. For example, for the HDFC BANK, buying 1 lot gives you the option to buy 550 shares of HDFC BANK.
    2. Options for the indices like NIFTY or BANKNIFTY are cash-settled. That is, if your call option closes ITM, you will be credited the amount of the profit and vice versa for OTM options.

RATIONALE

  • While shorting a call your outlook is bearish, you are expecting the price to fall.
  • The rationale is to pick up short-term premium income as the stock develops price weakness

NET POSITION

  • This is a net credit transaction since you are receiving a premium for the call

ADVANTAGES

  • If done correctly, you can profit from falling or range-bound stocks with the short call

DISADVANTAGES

  • Uncapped risk potential if the stock rises
  • A risky strategy and according to us should never be recommended

EXITING THE POSITION

  • Buyback the option you sold (buy to close) or wait for the sold option to expire worthless (if ITM) so that you can keep the premium you received

MITIGATING A LOSS

  • Use the underlying asset or stock to set up your stop loss

Cost

Net credit trade. You receive the premium

Maximum Risk

Uncapped

Maximum Reward

Limited to the premium received for selling the call

Break-even

Strike price + Call Premium received

Margin Required

As per Margin requirement of broker and Stock Exchange

Effects of Time decay

Time decay is your friend. You want the price of the call you sold to approach zero.

Effects of Volatility

After you are in the trade, you want the volatility to decrease. This will decrease the price of the call you sold.

EXPERT TIP

  1. If you must use this strategy (we don’t suggest it), work with OTM options. Select a strike at least one standard deviation away from the current price. This will put the probability of success in your favor.
  2. Working with Index options is a better idea since the volatility of individual stocks tends to cancel each other out. Thereby giving the index a more stable outlook.

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