Short Call Option Explained
Now we are going to start getting a little bit more advanced on our discussion about trading options as we look at shorting call options as opposed to buying call options.
As an option seller you have an opportunity to take it in a credit and let the option expire worthless, leaving you with the entire credit as a profit. With a short call option, you agree to sell underlying stock at the strike price at expiration and if the stock never makes it to that price then you keep the premium you took in on the initial sale.
This is where our discussion about high probability trading starts to accelerate because you have the ability to sell options far OTM which gives you a high probability of success and allows you to generate income in the process.
In this video, we’re going to start going over a short call option or a naked call option. As always, we’ll start here with the market outlook. This strategy is really for the trader who's expecting a steady falling stock price during the life of an option and more importantly, considers the likelihood of a rally very remote.
If you have an outlook on a stock that is neutral to negative or neutral to bearish, then this is a good strategy for you to collect some premium. It's typically considered the riskiest option strategy, and I would have to agree. It is the riskiest option strategy *if you trade this on single stocks.
If you go for the strategy on things like indexes and some of the other commodities, some of the bigger commodities like gold, oil, silver, etcetera, then your risk is a little bit limited in that you don't have the unlimited upside potential of the stock.
With the stock, you do have a huge, huge upside risk and that stocks can double, triple, quadruple overnight if they get bought out. That is a bit risk, and we’ll talk about that later.
Now, the only real goal for writing an uncovered call or a short call or a naked call, whatever you want to call it, is to earn the premium that you collect as income. Now, how do you set these up? They’re very easy to set up since it’s just a single leg option order.
You simply sell a call option. Usually, your broker will have a sell to open or a sell to initiate a position order; then you’re going to sell this option with a strike price and expiration period that you desire.
You can sell this front-month expiration a couple of months out any strike price you want. Typically, you’re going to sell the call, and it’s going to be out of the money because the more conservative you are, the further out of the money you’re going to sell these options.
You’re not going to sell these options if they’re in the money. For example here: If the stock is trading at 48, we’d like to sell an option that’s let’s say 50 which is out of the money, it's away from the market. We’re not going to go ahead and sell an option that's at let's say 40 because that’s going to be an in the money call, not a good trade.
What’s the risk? Well, the maximum risk is unlimited. It has no upside cap. It can go up forever. If you sell a call option and the stock price rises, we all know that the stock price is not range bound in any way, shape or form.
As the stock continues higher with no ceiling, so do your losses. As a trader, you would then be required to sell the stock at the lower price and buy it back at the higher price. Remember that we’re selling options here, so we have an obligation.
This is different than if you're going to buy options where you have a choice or an option. With option selling, you have an obligation. You have to buy the stock at that strike price if you get exercised.
You’d be forced to sell the stock at the lower strike price and buy it at the higher open market price which would be really bad. This is a very real threat for individual stocks like I said, but not for indexes and commodities. They do not have this big of a threat. There's obviously still the upside threat, but it's much, much more contained.
When we talk about profit potential like I had mentioned earlier, the maximum gain is limited to just the premium you took in during the sale of the call. You’re going to sell the option, take in premium right off the bat, in this case, $300, you’re going to get that $300 right into your account.
That’s the maximum you can make on this strategy. The best scenario is for the stock to close anywhere below the strike price at expiration. In our case here, the option pivots or turns at 50, so that’s where the strike price is.
If the stock closes anywhere below 50, you see that our profit loss here remains $300. That's what we want to happen. You’re going to be mildly bearish or negative on the stock. You don't think there's going to be a rally any time soon which is why you’re entering this position in the first place.
Now, in that case, that it does close anywhere below the strike price, you don't have to do anything to close out the trade, the option expires worthless, you keep all the premium, and the best part is you save the commissions of having to reverse the trade.
Volatility has a negative impact on this strategy, everything else being equal. Remember that volatility tends to boost the value of any options and since we want the value of our option to go to zero so that we can keep all the premium, we want to expire worthlessly, big volatility moves can be harmful.
At the money, options will have a greater risk than out of the money options. If you sell this option let's say all the way out here at 60, then you don't have as high of a risk of a big volatility move that’s going to be negative to your portfolio.
At the money options and in the money options are obviously going to have a bigger effect on volatility. Time decay on these strategies is positive for our short calls. We want time decay to occur.
Remember that we’re selling options, so in our case, the best scenario is for these options to expire worthlessly. And every day that passes that the stock does not trade above 50 is a really good day.
The value of the option declines every single day. As we get closer to expiration without the stock moving, the better. As expiration approaches and the option moves towards its intrinsic value, so for out of the money options would be zero, that's the ideal scenario.
We want this profit that we have to continue to rack up money in our trading account month after month by having positive time decay feature on the strategy.
The breakeven points for this are easy to calculate. All you’re going to do is take your short… This should be a called strike. Sorry for the typo. You’re going to take your short call strike and add the premium that you receive.
In this case, we shorted a call at 50, we’re going to add the premium of 300, so our new breakeven price is going to be 53, again, very easy to calculate. But let’s take a look at an example using the profit loss diagram that we’ve had up here the whole time.
Let’s say the stock is trading at $48. We’re going to sell one call for $300. Again, I’m sorry about the typos. But we’re going to sell one 50 calls for $300. That's going to bring in a credit of $300 to our account. Now, the maximum loss on this strategy is unlimited.
This underlying stock could go up to infinity, and we would have huge losses. The maximum profit is the $300 premium that we received initially. That's our max profit. We can’t make any more than that. We can make less, but we can’t make anymore.
Some tips and tricks that I've learned over the years with short calls: Short calls are one of my favorite strategies if they’re used correctly and only on indexes and commodities. I never trade short call options on any individual stocks.
That is asking for trouble. I prefer to sell deep out of the money calls with historical probabilities of success between 90% and 95%. What that means is that I sell call options that have historically always expired worthless.
It’s the one in a million chance that they're not going to and I’ll manage risk appropriately to protect against that big move in volatility or the big move in the underlying stock. Make sure that you avoid selling close to the market and in low volatility environments.
Remember, low volatility is okay, but if volatility starts increasing, that’s really bad for the strategy. We want to sell options far from the market during periods of high volatility. That's the best time.
And if done properly, selling calls can be a non-directional strategy for monthly income. I've proved it over the last six to seven years now, and you can see all of my performance for our naked portfolio which includes naked puts and naked calls.
As always, I hope you guys enjoyed this video and thanks for watching. If you like the video, please take a second to share it on your favorite social network with any of your friends, family, or colleagues right below.
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