Selling a naked call option is a levered alternative to short selling stock. Selling single options is considered “naked” because there is no risk protection if the stock moves against the position.
Because options are levered instruments, each short call contract is equivalent to selling 100 shares of stock. Naked call options require margin to protect against large price increases in the underlying asset.
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 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 position is initiated when a seller writes a call option contract. Call options are listed in an options chain and provide relevant information for every strike price and expiration available, including the bid and ask price. The credit received at trade entry is called the premium. Market participants consider multiple factors to assess the option premium's 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 when the call is sold. However, the risk is unlimited if the underlying asset experiences an increase in price.
For example, if a short call option with a strike price of $100 is sold for $5.00, the maximum profit potential is $500. The maximum loss is undefined above the break-even point. The strike price plus the premium collected equals the break-even price of $105. If the underlying stock price is above the break-even point at expiration, the position 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 the minimum price an investor is willing to recieve (limit order). Once a call option is sold, cash is credited to the trading account.
- Sell-to-open: $100 call
Because selling call options has significant undefined risk, the broker will hold margin against the account to cover potential losses. The margin amount depends on the broker, the stock’s price, and market volatility. Margin is not static and may 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 (ITM) 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 is out-of-the-money (OTM). The contract 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. All else being equal, options contracts with more time until expiration have higher prices because there is more time for the underlying asset to experience price movement. As time until expiration decreases, the option price goes down. Therefore, time decay, or theta, works in favor of call option sellers because an option's value will decrease as expiration approaches.
Implied volatility reflects the possibility of future price movements. Higher implied volatility results in higher option prices because there is an expectation the price may move more than expected in the future. As implied volatility decreases, a call option contract will lose value and the seller may purchase the contract for less money than it was sold. Options sellers benefit when implied volatility decreases before expiration.
Short call positions can be managed during a trade. A single-leg short call option can be adjusted to minimize risk.
If the position is challenged, a call option can be purchased at a higher strike price to convert the short call into a bear call credit spread. The long option defines the position's risk, but lowers the profit potential to the width of the spread minus the credit received.
For example, if a $100 call option is sold, a $110 call option can be purchased. If the long call costs $2.00, the max profit potential is reduced to $3.00. However, the maximum risk is defined at $700 if the underlying asset is above $110 at expiration.
- Buy-to-open: $110 call
If an investor wants to extend the trade, the short call option can be rolled out to a future expiration date. Rolling out the option requires buying-to-close (BTC) the short call and selling-to-open (STO) a new call option with the same strike price for a future date. Rolling the option should result in additional credit, which will widen the break-even price and increase the profit potential relative to the original position. The risk will be reduced by the amount of credit received but is still undefined.
For example, if a short call with a $100 strike price has a May expiration date, the position could closed and reopened with a June expiration date. If the adjustment receives $2.00 of premium, the break-even point is extended to $107.
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.
For example, if the position is challenged, a put with a $100 strike price could be sold. If an additional $5.00 of credit is received, the max profit increases to $1,000 and the break-even price moves up to $110.
- Sell-to-open: $100 put
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 decline 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 offset.