Selling a naked call option is a levered alternative to selling shares of stock. Selling single options is considered “naked” because there is no downside protection if the stock moves against the position.
Because options are levered, each contract is equivalent to selling 100 shares of stock. Naked call options require margin to protect against large price increases.
A short call is sold when the seller believes the price of the underlying asset will be below the strike price on or before the expiration date and/or implied volatility will decrease. The closer the strike price is to the underlying’s price, the more credit will be received.
Selling a call option can be used to enter a short position if the investor wishes to sell the underlying stock. Because selling options collects a premium, initiating a short position with a short call reduces the cost basis if the call option is ultimately assigned to the option seller.
A short call trade is initiated when a seller writes a call option contract. Call options are listed in an options chain and provide relevant information regarding each option for every strike price and expiration available, including the bid and ask price. The amount received at trade entry is called the premium. Market participants will consider multiple factors to assess the option’s premium value, including the strike price relative to the stock price, time until expiration, and volatility.
The payoff diagram for a short call represents the risk involved with selling naked options. Profit potential is limited to the amount of credit received. However, the risk is unlimited if the underlying asset experiences an increase in price. Selling a short call collects a credit, and the amount received is the most an investor can make on the trade.
For example, if a short call option with a strike price of $100 is sold for $5.00 of credit, the maximum profit potential is limited to $500, and the maximum loss is undefined above the break-even point. The strike price plus the premium collected equals the break-even price of $105. Anything above the break-even price will result in a loss.
To enter a short call position, a sell-to-open (STO) order is sent to the broker. The order is either filled at the asking price (market order) or at a specific price an investor is willing to collect (limit order). Once a call option is sold, cash is credited to the trading account.
Because selling call options has undefined risk, the broker will hold margin against the account to cover potential losses. The amount of margin depends on the broker, the stock’s price, and market volatility. Margin is not static and will increase or decrease as volatility fluctuates. The higher the volatility, the more margin required to hold the short call position.
There are multiple ways to exit a short call position. Anytime before expiration, a buy-to-close (BTC) order can be entered, and the contract will be purchased at the market or limit price. The premium paid will be debited from the account. If the contract is purchased for more premium than initially collected, a loss is realized. If the contract is purchased for less premium than initially collected, a profit is realized.
The buyer of the long call contract can choose to exercise the option at any time, and the seller is obligated to sell 100 shares at the strike price. If the short call option is in-the-money at expiration, the option will automatically be assigned to the option seller. If the stock price is below the strike price at expiration, the option will expire worthless, and the seller will keep the entire premium initially collected.
Time remaining until expiration and implied volatility make up an option’s extrinsic value and impact the premium price. Short call options contracts with more time until expiration will have higher prices because there is more time for the underlying asset to experience price movement. As time until expiration decreases, the price of the call option goes down. Time decay, or Theta, works in favor of call option sellers because the contract’s time value will decline as expiration approaches.
Implied volatility reflects the possibility of future price movements. Higher implied volatility results in a higher price of short call options because there is an expectation the price will move more in the future. As implied volatility decreases, the call option contract will lose value and allow the seller to purchase the contract back for less money. Call options sellers want to sell options when the expectation is implied volatility will be lower on or before expiration.
Short call options positions can be managed during a trade. Short call positions where the underlying security’s price moves away from the short call strike price can be adjusted to extend the time duration of the trade or converted to a risk-defined credit position to minimize loss. The ability to roll options positions into the future allows the trade more time to become profitable and may potentially bring in more credit.
If the stock price rises above the short call strike price, a call option can be purchased at a higher strike price to convert the position into a bear call credit spread. This will decrease the maximum loss on the trade.
For example, if a $100 call option is sold, a $110 call option can be purchased. This will lower the overall credit received on the original position. However, doing so will limit the maximum loss on the position to the width of the spread minus the credit received.
If an investor wants to extend the trade, the short call option can be rolled out to future expiration dates. Rolling out the option requires buying-to-close (BTC) the currently held position and selling-to-open (STO) an option with the same strike price at a future date. Doing so should result in receiving credit and will extend the break-even price and increase the profit potential relative to the original position. The risk will be reduced by the amount of the credit received but is still undefined.
To hedge a short call, an investor may sell a put with the same strike price and expiration date, thereby creating a short straddle. This will add additional credit and extend the break-even price above and below the centered strike price of the short straddle equal to the amount of premium collected. While this increases the premium received, the risk is still undefined and potentially substantial.
Another strategy to hedge a short call is to buy a call above the original strike price to create a bear call credit spread. Adding the long call will cost money but reduces the maximum loss to the width of the spread minus total credit received. The maximum profit potential is still limited to total credit received and will only be realized if the underlying price stays below the short call strike price.
A synthetic short call combines short stock with a short put option at the strike price of the original short stock position. This creates a synthetic short call because the payoff diagram is similar to a single short call option. As with a naked short call, the expectation is that the underlying price will fall before expiration.
Selling the put will collect a premium, but the risk beyond the premium received is still unlimited if the stock continues to rise. The maximum profit potential is limited to the premium collected for the short put. If the stock closes below the strike price at expiration, the short stock will be covered when the short put is exercised, and the shares will cancel out.