What Is a Short Call in Options Trading, and How Does It Work?

What Is a Short Call?

A short call is an options trading strategy that involves a trader selling (or "writing) a call option with the expectation that the price of the underlying asset will drop. The option buyer, meanwhile, is betting that the price will rise.

Two outcomes are possible:

• If the price drops, the transaction will not be completed but the seller of the short call seller will pocket the premium for the options contract. The premium is based on the market value of the underlying asset.
• If the price increases, the buyer of the short call will complete the transaction and collect the difference between the options price and the current market price of the underlying stock.

Short calls have limited profit potential and the theoretical risk of unlimited losses. They're usually used only by experienced traders and investors who specialize in options trading.

How a Short Call Works

A short call is a bearish trading strategy. The option seller, who is called the writer, believes that the price of the stock underlying the option will decrease.

Calls give the buyer of the option the right to buy the underlying security at a specified price (called the strike price) before the option contract expires.

The writer of the call option receives a premium paid by the buyer. The writer must deliver the underlying shares to the call buyer if the buyer exercises the option.

What Happens Next

The success of the short call strategy rests on the option contract expiring worthless. That way, the trader banks the profit from the premium.

For this to happen, the price of the underlying security must fall below the strike price. If it does, the buyer won't exercise the option.

If the price rises, the option will be exercised because the buyer can get the shares at the strike price and immediately sell them for a profit at the higher market price.

The Seller's Risk

For the seller, there’s unlimited exposure during the length of time the option is viable. The underlying stock's price could rise above the strike price at any time until the expiration date. The option would then be exercised.

Once that happens, the seller must buy the shares at the current price. That price could potentially be much higher than the strike price that the buyer will be paying.

A call by a seller who doesn't already own the underlying shares of an option is selling a naked short call. To limit losses, some traders will exercise a short call while owning the underlying security. This is known as a covered call.

The alternative is to close out their naked short position, accepting a loss that's less than what they'd lose if the option were assigned (exercised).

Example of a Short Call

Say that shares of Humbucker Holdings are in a strong uptrend and are trading near $100 per share. However, a trader believes that Humbucker is overvalued and will fall to $50 a share.

With that in mind, the trader sells a call with a strike price of $110 and a premium of $1. The trader will receive a net premium credit of $100 ($1.00 x 100 shares).

The price of Humbucker stock does indeed drop. The calls expire worthless and unexercised. The trader gets the full amount of the premium as profit. The strategy worked.

When the Strategy Fails

However, it could go the other way. Humbucker share prices could continue moving up. This creates a theoretically limitless risk for the call writer.

For example, say the shares move up to $200 within a few months. The call holder exercises the option and buys the shares at the $90 strike price. T

he shares must be delivered to the call holder. The call writer must buy 100 shares at the current market price of $200 per share. This is the trader's result:

Buy 100 shares at $200 per share = $20,000

Receive $90 per share from buyer = $9,000

Loss to trader is $20,000 - $9,000 = ($11,000)

Trader applies $100 premium received for a total loss of ($10,900)

Short Calls vs. Long Puts

A short call strategy is one of two basic bearish strategies involving options. The other is buying puts.

Put options give the holder the right to sell a security at a certain price within a specific time frame. Going long on puts, as traders say, is also a bet that prices will fall, but the strategy works differently.

Say that our trader still believes Humbucker stock is headed for a fall. The trader will buy a put with a $90 strike price for a $1.00 premium. The trader spends $100 for the right to sell shares at $90 even if the actual market price falls to $50.

Of course, if the stock does not drop below $90, the trader will have lost the premium paid for the protection.

The Bottom Line

The writer of a short option is making a bet that the stock underlying the option will decline in price before the option expires. Win or lose, the writer collects a premium, or fee, for selling the option. But losing this bet can mean unlimited losses for the writer. The option buyer is owed a number of shares of that stock at the current market price.

Options trading in general is best left to the professionals who dominate this market.