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Lesson 3:

Understanding Sold

(Short) Calls

A short call is the other side of a long call. Now let's turn our attention to the short call writer/seller. Option sellers are required to fulfil the terms of the contract at the buyer's discretion.

Lesson 3: Understanding Sold (Short) Calls

Understanding Sold (Short) Calls

short call

Short calls are sold to open

Let’s break down a short call. Short means sold and call means contains the right to buy. To create a short call, the trader sells to open the call and receives a premium in the form of a credit. Sold contracts are intended to contain as little value as possible.

Maximum loss is unlimited

Only option buyers can execute upon the terms of the contract, the short call holder is obligated to fulfil those terms. This means that long calls are exercisable, and short calls are assigned. In this example, the short call holder sold the right to buy ABC at $100 at any time through the expiration date . If the buyer chooses to execute upon this contract, the short call holder is obligated to sell 100 shares of ABC at the $100 strike price. In simpler terms, it’s the buyer’s decision, they decide when they would like to own the shares, if at all. If they decide to own the shares at the strike, the short call holder sells the shares to them at that price. The short call holder does not want this to occur. The short call holder receives a premium (options price) for the contract. As ABC can increase to an infinite amount, this means that the short call holder may have to purchase ABC at an infinitely high price to fulfil their obligation to sell the shares at the strike. This is how the short call writer faces unlimited loss potential if they do not already own the underlying security or another offsetting long position.

Lesson 3: Understanding Sold (Short) Calls

Understanding Sold (Short) Calls

short call

Short calls have limited profit potential

When selling an option contract, the contract seller wants the option to deplete in value and recognizes maximum gain when the option is completely worthless. The long call holder owns the right to buy at the $100 per share predetermined price known as the strike price. Therefore, for this contract to not have any value, ABC stock needs to remain below the $100 strike price. If ABC remains below the strike price, this means that it is more favorable to purchase the stock on the market than execute upon the terms of the contract. The short call writer will be able to purchase the contract back at a lower price or keep the entire premium if held until expiration day when ABC is trading below the strike. This is the ideal outcome.

Time is working for short options

Options with longer expiration dates are more expensive as there is more time for the option position to rise in value. As the option nears expiration, the time value component of the option’s premium will deplete. When selling options, the time decay depletion of the premium is beneficial. Because of this, ABC can remain at or below the $100 strike price making the short call holder profitable. Thus, a short call profits in a neutral or bearish environment. As the options premium depletes in value, the option seller can buy to close the short call at a lower price.

Lesson 3: Understanding Sold (Short) Calls

Short Call

Profit/Loss at Expiration

profit and loss

In this example, this option is out-of-the-money or in other words, does not contain any executable/intrinsic value when the underlying position (ABC) is trading below the $100 strike price. This is because the call contains the right to buy 100 shares of ABC at $100. Therefore, if ABC is trading at $99.99 or lower, the option does not contain executable value as buying at the strike is less advantageous than the market price. Any option that is out-of-the-money only contains extrinsic value which will deplete as the option nears expiration. If ABC continues to trade below the $100 call strike at expiration, the call option will have no intrinsic or extrinsic value and will simply expire worthless. Therefore, a short call option profits from a neutral to downwards movement in the underlying and as the option nears expiration, time value depletes from the premium.

Lesson 3: Understanding Sold (Short) Calls

Key Takeaways

checklist

1. A short call option is a sold option that contains the right to buy. The call seller is obligated to sell 100 shares of the underlying asset at the strike price executable at any time by the long call holder through the expiration date. The contract is sold for a premium, the short option holder wants the option to not contain any value to keep the premium.

2. To create a short call option, the investor will sell to open the call. The value of the call option will change during the lifetime of the contract and, at any time, can be bought to close. This generates either a profit or a loss on the trade.

3. A short call is neutral to bearish and profits if the underlying remains below the strike price. As the underlying position can increase to an infinite price requiring the seller to fulfill the terms of the contract, the strategy has unlimited loss potential.

4. All else equal, time works for this strategy. This is because the extrinsic value of an option will depreciate to $0 by expiration and in doing so, will reduce the overall premium of an option allowing the short call holder to purchase the call to close at a lower price.

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Lesson 3:

Knowledge Check

Lesson 3: Understanding Sold (Short) Calls

Knowledge Check

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What is the risk potential for a trader who has sold a short call option?

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Lesson 3: Understanding Sold (Short) Calls

Knowledge Check

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How does a short call writer realize maximum profit?

(Select an answer below)

Lesson 3: Understanding Sold (Short) Calls

Knowledge Check

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How does time decay affect a short call option as it approaches expiration?

(Select an answer below)

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Understanding Sold (Short) Calls

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