Back to Basics Friday: Selling Calls

Let’s say the market turns bearish.  I realize this is hard to believe, but at some point, it will happen.

You are going to need a bearish to neutral strategy that will capitalize on time decay, downward moves in vol and certain a down move in the underlying stock.

So what do you do…  Sell calls.

And you can even sell calls when there is a small positive move in the underlying stock…

One thing to keep in mind – due to the RISKY nature of a short call, many brokers require a special approval level to trade this type of strategy.  Theoretically, your loss could be unlimited.  Theoretical definitely, realistic, probably not!

So here are some key points to take away from this article.


Key Points

  • Selling calls involves potentially unlimited risk
  • Unlike selling puts, selling calls can never be covered
  • Selling calls (shorting) will be profitable IF the stock price stays the same, goes down or moves up a small amount

Short Call Option Strategy Definition

-Sell 1 call

Note: like most options strategies, you can sell calls in-the-money (ITM), at-the-money (ATM), or out-of-the-money (OTM).

Unlike selling puts, selling short calls can never be covered unless the seller owns the appropriate amount of the underlying asset; if the underlying asset is owned, the strategy is called a covered call.

If a trader sells a put, there is always a defined loss for the trade. The maximum loss for a naked short call is theoretically unlimited, so short calls are, by definition, naked (uncovered) options positions.

Short Call Option Strategy Example

Stock ABC is trading at $60 a share.

Sell 62 call for $0.30

Maximum Profit and Loss for a Short Call

Maximum profit for a short call = THE PREMIUM YOU RECEIVED

Maximum loss for a short call = UNLIMITED

 

Break-Even for a Short Call

The breakeven point for a short call = premium received (plus) strike price of short call.

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In the example above, the breakeven point at expiration for selling 1 call in stock ABC would be $62.30. In other words, stock ABC can climb to $62.30 per share at expiration before this trade loses money.

Because this is the break-even point at expiration, ABC can trade at $62.30 prior to expiration and the short $62 call will likely not be at a break-even; it will likely be at a loss because of time premium built into the $62 call.

Why Would Anyone Trade Short Calls?

It’s a great question and one I’ve asked myself many times.

Most traders will go their entire careers without ever selling a call because of its unlimited risk.  I am not one of those traders and haven’t been for years.

In fact, it has gotten to the point where I almost only sell calls and puts, naked and covered.

Like me, there are plenty of options traders who will almost exclusively sell the premium attached to calls.

Why?



Calls will never run too far… in fact, the main reason why someone would choose to short a call over a put is that reason.  A stock COULD go to 0 very quickly.  It’s rare, but it happens.  There are enough examples out there to point at… If a stock went to 0, it would be a DISASTER for a short put.

The upside for 99% of options is nowhere near the same as the downside which is why puts typically carry more premium.

Essentially, when you sell (short) a call, you are mitigating the risk of a widespread market crash that would wipe out the underlying asset.

Beware The Hidden Risk of the Selling Calls

There is an exception to the upside vs downside risk with commodities and certain stocks.

There are times that especially high-beta stocks, can gap up 40% on upgrade, rumors, buyouts, etc…

And it is this reason why many traders only sell calls on optionable indices like the SPX, NDX, and SPY. The chances of a massive index like the S&P 500 trading up 25% overnight is laughable.  It virtually eliminates the upside risk by selling calls.

What Are The Margin Requirements for Short Calls

You will find there are a few things that factor into your buying power when selling calls. The general rule for an average margin account, 20% of the underlying asset is required for each uncovered call.  (Some are higher than that – Schwab is when they pay attention)

Margin requirements for selling calls also heavily depends on the underlying asset. Highly volatile stocks usually have higher requirements.

The single best way to determine the margin impact for selling a call is to preview your order before transmitting it using a live account.

Enter the Greeks – What About Theta (Time) Decay? 

Theta (time) decay is very favorable for short calls that are OTM or ATM. In reality t, me decay is almost always on the side of the seller of an option.  As you recall from past articles, the impact of time decay depends on how many days there are until expiration, but time premium has to be priced out of the calls.

In fact, collecting premium is what drives most traders to sell calls in the first place.

As expiration approaches, theta will have to decay; it’s a certainty.

Other components of an option’s price, however, can inflate prices, like volatility.

The Big Question, When Should I Close (cover) My Short Call?

A very good buddy of mine was a mega trader on Wall Street.  He told me years back you never want to get steamrolled picking up nickels.

So as a general rule, a call should be BTC-Covered- Closed when the premium is less than $.05.  I NEVER do that.  His voice is in my head.  In my experience, I usually close well before we get there and go back to bed.  It’s a matter of how much you want to really pay attention to things.  If you are comfortable with a winner, take it off sooner, and walk away HAPPY!

The biggest issue comes from when a short call goes against you that becomes an issue.

Once a short call gets deep enough in-the-money, theta will have less and less of an effect on the price of the call.

You can continue to “roll” the unprofitable position to a later expiration series, but a deep ITM short call is equivalent to shorting the underlying, except with additional leverage.



If the underlying asset doesn’t decline, neither will the value of the short ITM call.

So What Is There To Know about Expiration?

Short calls on US stocks that are ITM can technically be exercised at anytime prior to expiration by the option buyer.

Although this is highly unlikely, it is possible although but has never happened to me.

Similarly, for writing calls on individual stocks, if there is not enough stock available to borrow, or there is a hard-to-borrow fee, this can create a predicament as well. Regardless, everything can be avoided my properly monitoring expiring positions.

Expiration details for options on stock indices and futures vary, but as a premium seller it behooves you to stay on top of all ITM short options positions that are approaching expiration.

Important Call Selling Tips

Selling calls can be a great way to capture option premium. With short calls that are OTM, money can be made if the stock moves up slightly, does nothing, or declines dramatically. Despite the fact that there are technically three ways to make money with short calls, it’s important to remember that selling calls is still a bearish options trading strategy at heart.

Sharp increases in volatility and the price of the underlying asset can wreak havoc on a short call position. Having said that, sharp decreases in volatility and decreases in the price of the underlying asset, in addition to thetadecay, can make selling calls very profitable.

This is because volatility (as discussed in the beginner’s guide to options) is a major component in an option’s price.

Selling calls should by no means be a trader’s sole strategy, but it’s unequivocally an incredibly powerful strategy to be familiar with because it’s one of the only ways to sell option premium without a huge financial crisis, market-crash-type of risk.

— The Option Specialist

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About the Author: The Option Specialist