This chapter covers the fundamentals of short call options contracts. To get comfortable with the language used when discussing options, watch this video:
When an investor goes short a call, they’re bearish on the underlying security’s market price. Selling a call creates an obligation: if the option is assigned (exercised), the writer must sell the stock at the strike price.
Let’s work through a few examples to understand short calls better:
Short 1 ABC Sep 75 call @ $6
This contract obligates the writer to sell ABC stock at $75 per share if assigned. The writer received $600 for selling the option ($6 premium x 100 shares). The contract expires on the third Friday in September.
The investor is betting ABC stock’s market price stays at or below $75 through expiration. If the market price rises above $75, the holder may exercise the option, which can create losses for the writer.
Math-based options questions should be expected on the exam. They typically ask about potential gains, losses, and breakeven values. Let’s go through each.
An investor goes short 1 ABC Sep 75 call @ $6. The market price rises to $100. What is the gain or loss?
Can you figure it out?
Answer = $1,900 loss
| Action | Result |
|---|---|
| Sell call | +$600 |
| Buy shares | -$10,000 |
| Assigned - sell shares | +$7,500 |
| Total | -$1,900 |
The market price rose to $100, so the option is in the money by $25 ($100 − $75). That’s bad for the seller.
We can assume the investor is assigned, which requires selling 100 ABC shares at $75. If the investor doesn’t already own the shares, they must buy 100 shares in the market for $100 and then sell them for $75.
The further the underlying security’s market price rises, the more a call writer loses if assigned. Imagine if the market price went to $125, $200, $250, etc. While large swings in the market are relatively uncommon, they can (and do) occur. Because there’s no ceiling on how high a stock price can go, the maximum loss for a short call is unlimited.
When an option is sold with no hedge (protection), it’s considered naked. “Naked” simply means the short option position is exposed to significant risk. A short call is risky because assignment may force the investor to buy shares at the higher market price and then sell those shares at the lower strike price. Since the market has no ceiling, the potential loss is unlimited.
In future sections, you’ll learn how investors protect themselves from risk on short options. For now, here is a quick list of investments that would cover a short call:
You may have noticed a pattern in the list above. If the writer already owns the shares, or holds something that can be converted (preferred stock or bonds) or exercised (rights or warrants) into the shares, they can deliver shares without having to buy them at the higher market price.
While the maximum loss for a short naked call is unlimited, call writers don’t always lose significant amounts of money. Even if the option goes in the money (gains intrinsic value), the seller doesn’t have an overall loss until the assignment loss exceeds the premium received.
Let’s go through another example:
An investor goes short 1 ABC Sep 75 call @ $6. The market price rises to $81. What is the gain or loss?
Answer = $0 (breakeven)
| Action | Result |
|---|---|
| Sell call | +$600 |
| Buy shares | -$8,100 |
| Assigned - sell shares | +$7,500 |
| Total | $0 |
At $81, the option is $6 in the money ($81 − $75). If the option is exercised (a safe assumption), the investor buys ABC shares at $81 (the market price) and sells them at $75 (the strike price).
The breakeven for call contracts can be found using this formula:
Did you notice the breakeven formula for long calls is the same? Since the long and short sides are opposites of the same contract, they break even at the same stock price.
If ABC’s market price doesn’t rise too far past $75, the investor could still make a profit. For example:
An investor goes short 1 ABC Sep 75 call @ $6. The market price rises to $79. What is the gain or loss?
Answer = $200 gain
| Action | Result |
|---|---|
| Sell call | +$600 |
| Buy shares | -$7,900 |
| Assigned - sell shares | +$7,500 |
| Total | +$200 |
At $79, the option is $4 in the money ($79 − $75). Assignment forces the investor to buy ABC shares at $79 and sell them at $75.
Expiration is the best-case scenario for investors writing (going short) options. If the option expires out of the money, the investor keeps the premium and never has to fulfill the obligation. The same applies to short call contracts.
An investor goes short 1 ABC Sep 75 call @ $6. The market price falls to $73. What is the gain or loss?
Answer = $600 gain
| Action | Result |
|---|---|
| Sell call | +$600 |
| Total | +$600 |
At $73, the option is $2 out of the money because the market price is below the $75 strike price. When the market price is at or below $75, the holder won’t exercise the call. They wouldn’t choose to buy stock for $75 when it’s trading for $73 in the market.
An easy way to remember when a call is likely to be exercised is the phrase “call up.” Calls are exercised only if the underlying security’s market price is above the strike price. That isn’t true here, so the option expires.
Investors with short options can only make the premium, nothing more. If exercise occurs, losses start reducing that premium and can eventually create an overall loss.
Writers can also perform closing transactions to exit their obligations before expiration.
An investor goes short 1 ABC Sep 75 call @ $6. After ABC’s market price rises to $79, the premium rises to $9, and the investor performs a closing purchase. What is the gain or loss?
Answer = $300 loss
| Action | Result |
|---|---|
| Sell call | +$600 |
| Close call | -$900 |
| Total | -$300 |
To find the profit or loss on a closing transaction, compare:
Here, the investor received $6 and later paid $9 to close the position. That’s a $3 net loss per share.
Since option premiums are quoted per share and each contract represents 100 shares, the total loss is $3 x 100 = $300.
Here’s a visual summarizing the important aspects of short calls:
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