1.3.2 Short calls
This chapter covers the fundamentals of short call options contracts. To gain a good understanding of the language used when discussing options, watch this video:
When an investor goes short a call, they are bearish on the underlying security’s market price. Selling a call obligates the investor to sell stock at the strike price if assigned (exercised). If the stock’s market price rises above the call’s strike price (“call up” - the call is “in the money”), the holder may exercise the option, forcing the writer to fulfill their obligation. If the market price falls below the strike price (the call is “out of the money”), the holder will not exercise the option, and the writer realizes a gain equal to the premium.
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), which expires on the third Friday in September. The investor is betting ABC stock’s market price stays at or below $75 before expiration. Otherwise, the holder will exercise the option, resulting in losses for the writer.
Math-based options questions should be expected on the exam. Normally, they involve 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 went to $100, and the option went “in the money” by $25. This is not good for the seller! We can safely assume the investor was assigned their contract, requiring a sale of 100 ABC shares at $75. Assuming they don’t own the shares, they must go to the market and purchase 100 shares for $100. The assignment results in a $2,500 loss ($25 loss x 100 shares). Factoring in the $600 premium received upfront brings the overall loss down to $1,900.
The further the underlying security’s market price rises, the more a call writer loses when 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. With no ceiling to the market, the maximum loss for a short call is unlimited.
When an option is sold with no hedge (protection), it is considered naked. Naked is a peculiar term, but it means the short option is subject to considerable risk. As you’ve learned, a short call is risky because it may result in the investor buying shares at the higher market price and then selling those shares at the lower strike price. The market has no ceiling, so the investor can lose unlimited money.
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:
*For a long call to cover a short call, the long call must maintain the same or lower strike price, plus the expiration must be the same or longer.
**A short call is considered covered if a banking institution provides a guarantee letter stating it will cover the costs related to an assignment.
You may have noticed a trend with the list above. If the writer owns the shares or obtains something convertible (preferred stock or bonds) or exercisable (rights or warrants) into the shares, they avoid significant risk. There’s no need to buy shares at the higher market price because they’re already owned or can be obtained without paying the high 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 must lose at least an amount equal to the premium to start losing money overall.
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.” The option gained intrinsic value, but the seller didn’t lose enough from the exercise to experience an overall loss.
Assuming the option is exercised (a safe assumption), the investor purchased ABC shares at $81 (the market price) and sold them at $75 (the strike price). This results in a $6 per share loss, or a $600 overall loss. However, the $600 premium received upfront offsets the assignment loss, and the investor breaks even.
The breakeven for call contracts can be found using this formula:
Did you notice the breakeven formula for long calls is the same? With the two sides acting as opposites, it shouldn’t be a surprise they both breakeven at the same point.
If ABC’s market price doesn’t rise too far past $75, the investor could 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.” The assignment resulted in a $4 per share loss as the investor was forced to purchase ABC shares in the market at $79 and sell them for $75. The overall loss from the assignment was $400 ($4 x 100 shares). When the upfront $600 premium received is included, the investor achieves an overall gain of $200.
Expiration is the best-case scenario for investors writing (going short) options. When this occurs, the investor receives a premium for an option that is never used (the obligation is not required to be fulfilled). 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.” When the market price is at or below $75, the holder does not exercise their option. Why would they exercise and buy stock for $75 when the market is trading it for $73? This is the best-case scenario for the call writer. They sold a call for $600 and didn’t have to do anything!
An easy way to determine if a call will be assigned is utilizing the phrase “call up.” Calls are only exercised if the underlying security’s market price is above the strike price. This is not the case in this example, so the option expires.
Investors with short options can only make the premium, nothing more. It only goes downhill from there. If an exercise occurs, losses will start eating away at the premium, potentially pushing the investor to a 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 for a closing transaction, we’ll compare the premium received for selling the option to the premium paid for closing it out. When the call was initially sold, the premium was $6. The market price increased, also causing the option’s premium to rise. When the option contract was bought (closing purchase), the premium was $9. This results in a $3 net loss (debit).
With option premiums representing 100 shares, the investor has a $300 overall loss.
Here’s a visual summarizing the important aspects of short calls:
Sign up for free to take 13 quiz questions on this topic