What is a Short Call in options Trading?

Short Call (selling or writing a call option): A warm welcome and enjoy reading. Here comes the third article in the basic series on options trading.

I assume that the first technical terms are known by the first article of the series “The Long Call”. If you like, you are welcome to look there again. The first article also explained the pricing of options. I also briefly touched on the influence of the Greeks.

In this article the perspective is changed for the first time. By selling or writing options, the trader is able to act as a writer. Here too we look at the advantages and disadvantages.

Options and warrants – important differences

Most newcomers to stock exchange trading start out as pure buyers. Those who start stock exchange trading with a small account use mainly leverage products and/or difference trading contracts to implement their market opinion.

This is basically not wrong. However, the behaviour of many financial derivatives is difficult to estimate for a beginner due to the sometimes peculiar constructs. The variety of these products has increased enormously, especially in Germany. The most common term ends in “-certificate”. Depending on parameters related to an underlying instrument, these instruments can behave in a similar way to purchased options. Unfortunately also completely different.

For many of these derivatives, the term warrant is also common. For some investors this leads to the assumption that options and the warrants mentioned are comparable products.

Warrants briefly described

In the case of a warrant, it is usually the case that it is issued by a financial institution. This financial institution then also sets the prices for these products. Using the WKN or ISIN, warrants can also be bought or sold on an exchange. Due to the large number of warrants issued, the market for a single product is relatively thin.

At the latest when trying to combine different warrants, the difference becomes clear. Combination orders cannot be created in this way. It is also not possible to act as a seller of a warrant if you do not already have it in your portfolio through a purchase.

In addition to the disadvantages, there is another risk: the issuing financial institution may go bankrupt. This scenario has not been so outlandish since the Lehman bankruptcy. In times of punitive interest rates, a prankster can assume that the masses of warrants issued are a good indication of new sources of income for the banks.

What is different about options

Options, on the other hand, are issued by the futures exchanges themselves and are standardised. The reference to the underlying asset, term and strike price only allows for one option each on the put and call side. This means that a larger number of market participants can be found to trade the corresponding options.

In addition, traders certified and controlled by the exchange (market makers) act as intermediaries. These provide fair buying and selling prices during trading hours. And they are obliged to buy and sell the contracts offered.

The broker is responsible to the Exchange for ensuring that his client can execute the transaction. Depending on the market situation, a security deposit (margin) is charged. This is blocked on the customer’s account for further transactions. In this way, all participants can be sure that the rights and obligations associated with the option are observed.

This is where the writer comes into play

The market makers like to have a balanced ratio of long and short positions in the books. The option sellers are welcome to take some risk. Here I also include strategies from combined options if they profit from the loss in time value.

Properties of the underlying – Implied volatility

In recent contributions we have worked out that the implied volatility (IV) is a good indication for estimating the option price. In Apple’s chart (AAPL), the line at the bottom shows the course of the implied volatility. The phases of high and low volatility are clearly visible. Since the option prices also rise in phases of high implied volatility, writer strategies are more appropriate in these market phases. Higher premium income is possible here. This optimizes the break-even points.

The large number of possible combinations of options has resulted in countless popular strategies. In this universe, there are also trades that do not necessarily provide for a valuation of implied volatility. For a single sold option, however, I always use the evaluation of the implied volatility.

Putting the implied volatility in relation

In order to be able to use the value of the current implied volatility (IV) for a Stillhalter trade, a consideration of the last 52 weeks has become established. The procedure is unanimously described by Tastytrade and almost all option traders as IV-Ranking (IVR). If several underlyings are available, the promising ones can be filtered out.

The calculation includes the high of the implied volatility from the last 52 weeks, the 52-week low and the current value. A rule of three then results in the formula as shown in the screenshot, and the result is shown in the blue field.

The short call in the option chain

Similar to the previous purchase of options, the prices can be taken from the broker’s option chain. For the trade in this example I chose a call on Apple with Strike 250. There is no fundamental change in the display of the options. For the sale of an option, this time the prices on the bid or money side count.

The short call (selling or writing a call option)

Depending on the bid-ask spread, an approximation to the mid-price is also possible here. This time, however, from the letter (ask) side. Otherwise, there is a risk of selling the option too cheaply. The premiums on the call side are lower due to the skew. With regard to the break-even, every cent counts.

Based on the right of the buyer of a call option to buy the underlying asset at the strike price, the seller now has a binding obligation:

The seller of the call option must sell the buyer 100 shares at the strike price when the option is exercised. If the price is not above the strike price, the buyer will probably not take advantage of this option. The option then expires worthless at the end of the term.

Trade management – duration and premium

In this case the seller has earned the premium in full. It is important to mention that the seller can also buy the option back at any time (of course while the exchange is open). This is a common practice in the context of a healthy portfolio and money management. This would close the position.

The attraction of holding an option until the full premium has been received is psychologically very great. This is precisely why closing the position prematurely is a good idea. Firstly, the risk of strong price movements increases towards the expiration date. On the other hand, it is often the case that around 50-80 percent of the premium is collected in a relatively short time compared to the total term.

This is often supported by corresponding price movements when the trade implements a market view. Then the risk of keeping the trade open until the end would be disproportionate. Just to earn a few extra dollars, the trader would still be exposed to the risk of a countermovement every day.

Studies and Backtests

At this point I would like to refer you to the informative video channels of Optionsuniversum and Tastytrade.
The advantages of a buyback before the expiration date are well explained here on the basis of detailed studies and back tests.
In addition, I recommend every options trader to conduct his own studies and back tests.

The profit and loss profile

The sale of a single option is a special feature. The P&L profile already known from Optionsuniversum shows that a relatively low premium income is offset by a clearly recognizable high risk. In the event of a strong upward market movement, the trader with a short call is quickly left without pants (shorts). For this reason, the term “naked option” has become established for the sale of individual contracts.

On the other hand, the game of probabilities is more on the side of the option seller. Various studies and backtests show partly euphoric values. Almost eighty percent of all options are expected to expire worthless. Therefore, systems named as writer strategies enjoy growing popularity. The loss in fair value feared by the buyer benefits the seller. The theta is positive. If he “keeps still” long enough, he can collect the option premium.

Keeping an eye on the risk

The risky side of the coin should nevertheless be given special attention. From the previous articles, I would like to remind you that the price of an option depends on various factors. For example, we have found that movements in the price of the underlying asset can cause strong fluctuations in the price of the option.

We like to advertise the fact that the premium for an option sold is immediately posted to the trading account. This is true, but at the same time the option is also available as an open position in the account. Initially, as a kind of “pending issue for redemption”, the price coincides with the income from the sale. When the price falls due to the loss of time value, the book profit of the position increases. Until finally, on the expiration date (out of the money), the entire premium ends up as a profit on the account.

Small formula for the current trade

In other words, at the time of the sale, the price of the option represents something like the zero point for the position.

I like to use a little formula to help:

  • Option price (sale) – option price (current) = current profit or loss
  • In the variant, the sign in the result is also equivalent to the profit (minus equals loss)

In the broker’s trading software, the current P&L is usually also displayed in this way. Or it can be adjusted.

If the price of the option increases during the term, the book loss of your position will also increase. Just as the option can be statistically worthless on the expiration date, the price can spiral to undreamt-of heights in the meantime. In addition, the broker’s margin requirement increases, which can lead to the forced liquidation of the position. After all, in the event of an exercise, you should be able to buy 100 shares in order to hand them over to the buyer.

The often mentioned “unlimited” loss

Since the price of an underlying asset can theoretically rise to immeasurable levels, the possible loss of a sold call option is also infinite. As far as I know, the price of all underlyings such as stocks, indices and commodities is limited to zero. However, I am also not aware of any underlying that has risen to infinity.

Based on the expected price movement, the broker’s margin requirement will be oriented in the short call. In the current example this would be around 2100 dollars.

The markets tend to exaggerate irrationally when the news is positive or negative. Suppose you have a short call position on the stock of a small pharmaceutical company. In the evening, the ticker announces that this company is being swallowed by a large corporation. The next day, the price will generate an extreme gap to the upside, without you having the chance to limit the loss.

I can only give a recommendation for short calls on shares as the underlying asset in two cases:

  • Short calls are traded in combination with other options, or
  • You own the underlying asset, in the example 100 Apple shares (so-called “covered call” strategy)

The covered call – the second dividend

If investors already have a large portfolio of shares and ETFs, the sale of calls out of the money is a good option. This procedure can be used to generate regular income. The risk remains manageable. In principle, any position in the underlying that matches the multiplier of the corresponding option is suitable.

The trader from the example with AAPL now buys 100 shares. Then we get the following P&L profile:

  • I have set up the stock position synthetically for presentation in the income statement profile. This is achieved by a bought call and a sold put. The strikes are as close as possible to the money and add up to a delta of 100. This position then behaves one to one like a trade in 100 shares. The premium for the sold call lowers the break even. (Share price minus premium > $ 221.66 – 0.76 = $ 220.90)

It is easy to see that when prices rise, the profit is capped by the sold call. The strike is chosen so far out of the money that the strike price will probably not be reached based on the chart. As a rule of thumb, a delta of around ten can also be used for the strike.

Now the following possibilities arise for the further course:

Management in Covered Call

For a pure equity position this is a neutral to positive situation. There are no book losses. In the case of dividend-bearing securities, the distributions can be collected. The premium for the sold call is now added. As long as the strike of the short call is not started, the strategy can be continued in such a market environment.

When the underlying asset falls

Here too, a positive aspect can be found for the share owner. The premium received dampens the loss, which is also expressed in the P&L by the reduced delta. (91 instead of 100). If the share price falls, the price of the call also falls. Unfortunately, the IV increase to be expected when the price falls dampens this effect somewhat. Nevertheless, in a falling market, it is advisable to buy back the short call at a residual value of around 20-25 percent. Then sell a new call with a lower strike at Delta 10.

Depending on the parameters remaining term, IVR and the amount of the premium, it is also possible to increase the remaining term of the new short call. Maturities between 30 and 60 days have proven to be successful.

Strongly rising underlying asset – the call runs into the money

The trader does not need to be afraid of this situation either. After all, the position is well in profit until then. As a rule of thumb, the short option could be bought back if the premium doubles. In most cases, this prevents the option from going into the money. Even in such a case, a new call can be sold out of the money immediately.

It becomes interesting if the buyer of the call exercises it. In this case, the premium is credited immediately and the shares are taken out of the account at the strike price. Even if the profit from the stock position is limited, the bottom line is a handsome sum.

If no exercise takes place, there is still the prospect of a price correction, so that the call is out of the money again and expires worthless. Hope is of course a bad advisor on the stock market. That is why there is also a plan B for the case of exercise.

Conclusion on Short Call (sale of a call option)

At first glance, the risks seem to predominate on the writer side. On the other hand, there are the probabilities. The frequency of extreme market movements can also be estimated statistically. The pricing of options in extreme situations should not be underestimated. In my own trades I prefer to work with combinations and a limited maximum risk at all times.

The Covered Call presented here is only one way of limiting the risk in sold options. The advantage is to generate additional income for the portfolio.

How do you get the shares back now?

This is where the circle of basic strategies closes. As a fourth building block, in the last part of the basic series, I will introduce the short put. Be curious about the possibility of still being paid for the purchase of shares.

Read my other articles about Options:

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