To profit from expected short-term neutral-to-bearish price action in a stock or market index.
Example of short call - uncovered
Sell 1 XYZ 100 Call at 3.30
In return for receiving the premium, the seller of a call assumes the obligation of delivering the underlying instrument at the strike price at any time until the expiration date. This obligation has unlimited risk, because the price of the underlying can rise indefinitely.
Speculators who sell uncovered calls hope that the price of the underlying stock or market index will trade sideways or decline so that the price of the call will decline. Since stock options in the U.S. typically cover 100 shares, the seller of the call in the example above receives $3.30 per share ($330 less commissions) and assumes the obligation to deliver 100 shares of XYZ stock at $100 per share until the expiration date (usually the third Friday of the expiration month).
In-the-money options are automatically exercised if they are one cent ($0.01) in the money. Therefore, if an uncovered short call position is open at expiration, it is highly likely that it will be assigned and a short stock position will be created. Since speculators who sell uncovered calls typically do not want a short stock position, the writers usually close the calls if they are in the money as expiration approaches. Short calls can be closed by entering a "buy to close" order.
The potential profit is limited to the premium received less commissions, and this profit is realized if the call is held to expiration and expires worthless.
Risk is unlimited, because the price of the underlying can rise indefinitely.
Breakeven stock price at expiration
Strike price plus premium received.
In this example: 100.00 + 3.30 = 103.30
Profit/Loss diagram and table: Short 100 Call @ 3.30
|Stock Price at Expiration||100 Call Sale Price||100 Call Value at Expiration||Profit/(Loss) at Expiration|
Appropriate market forecast
Selling a call uncovered requires a neutral-to-bearish forecast. The forecast must predict that the stock price will not rise above the break-even point before expiration.
Selling an uncovered call based on a neutral-to-bearish forecast requires both a high tolerance for risk and trading discipline. A high tolerance for risk is required, because risk is theoretically unlimited. In practice, a sharp price rise can cause very large losses, losses that could exceed account equity. A takeover bid or an unexpected announcement of good news might cause the underlying stock to gap up in price, which could result in such a loss. Trading discipline is required because the ability to “cut losses short” is an attribute of trading discipline. Many traders who sell uncovered calls have strict guidelines – which they adhere to – about closing positions when the market goes against the forecast.
Impact of stock price change
The value of a short call position changes opposite to changes in underlying price. Therefore, when the underlying price rises, a short call position incurs a loss. Also, call prices generally do not change dollar-for-dollar with changes in the price of the underlying stock. Rather, calls change in price based on their “delta.” The delta of a short at-the-money call is typically about -50%, so a $1 stock price decline causes an at-the-money short call to make about 50 cents per share. Similarly, a $1 stock price rise causes an at-the-money short call to lose about 50 cents per share. In-the-money short calls tend to have deltas between -50% and -100%. Out-of-the-money short calls tend to have deltas between zero and -50%.
Impact of change in volatility
Volatility is a measure of how much a stock price fluctuates in percentage terms, and volatility is a factor in option prices. As volatility rises, option prices tend to rise if other factors such as stock price and time to expiration remain constant. As a result, short call positions benefit from decreasing volatility and are hurt by rising volatility.
Impact of time
The time value portion of an option’s total price decreases as expiration approaches. This is known as time erosion. Short calls benefit from passing time if other factors remain constant.
Risk of early assignment
Stock options in the United States can be exercised on any business day, and the holder of a short option position has no control over when they will be required to fulfill the obligation. Therefore, the risk of early assignment is a real risk that must be considered.
Sellers of uncovered calls, therefore, must consider the risk of early assignment and should be aware of when the risk is greatest. Early assignment of stock options is generally related to dividends, and short calls that are assigned early are generally assigned on the day before the ex-dividend date. In-the-money calls whose time value is less than the dividend have a high likelihood of being assigned.
Potential position created at expiration
If a call is assigned, then stock is sold at the strike price of the call. In the case of an uncovered call where there is no offsetting long stock position, a short stock position is created. Since calls are automatically exercised at expiration if they are one cent ($0.01) in the money, if a seller of an uncovered call wants to avoid having a short stock position when a call is in the money, the short call must be closed prior to expiration.
Speculators who sell uncovered calls generally do not want a short position in the underlying stock. It is therefore necessary for such speculators to watch uncovered call positions closely and to close a position if the market moves against the neutral-to-bearish forecast.