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This chapter is from the book

1.2 Short (Naked) Call

Proficiency

Direction

Volatility

Asset Legs

Max Risk

Max Reward

Strategy Type

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N/A

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Advanced

Bearish

 

Short Call

Uncapped

Capped

Income

1.2.1 Description

Although simple to execute, shorting a call (without any form of cover) is a risky strategy, hence its categorization as an advanced strategy. A short call exposes you to uncapped risk if the stock rises meteorically, and brokers will only allow experienced options traders to trade the strategy in the first place.

A call is an option to buy, so it stands to reason that when you buy a call, you’re hoping that the underlying share price will rise. If you’re selling or shorting a call, it’s therefore logical that you’d want the stock to do the opposite—fall.

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Steps to Trading a Short Call

  1. Sell the call option with a strike price higher than the current stock price.

    • Remember that for option contracts in the U.S., one contract is for 100 shares. So when you see a price of 1.00 for a call, you will receive $100 for one contract.

    Steps In

    • Try to ensure that the stock is rangebound or trending downward, and is below a clearly identifiable area of resistance.

    Steps Out

    • Manage your position according to the rules defined in your trading plan.
    • Hopefully the stock will decline or remain static, allowing your sold option to expire worthless so you can keep the entire premium.
    • If the stock rises above your stop loss, then exit the position by buying back the calls.
    • Time decay will be eroding the value of your call every day, so all other things being equal, the call you sold will be declining in value every day, allowing you to buy it back for less than you bought it for, unless the underlying stock has risen of course.

1.2.2 Context

Outlook

  • Bearish—You are expecting a fall in the stock price; you are certainly not expecting a rise in the stock.

Rationale

  • To pick up short-term premium income as the stock develops price weakness.

Net Position

  • This is a net credit transaction because you are receiving a premium for the call.
  • Your maximum risk is uncapped.
  • Your maximum reward is capped to the price you receive for the call.

Effect of Time Decay

  • Time decay is helpful to your naked sold option, so take advantage of the maximum time erosion. Maximum time decay (or theta decay) occurs in the last month before the option’s expiration, so it makes sense to sell one-month-or-less options only.
  • Don’t be fooled by the false economy that selling longer options would be more lucrative. Compare a one-month option to a 12-month option and multiply the shorter option price by 12. You will see that you are receiving far more per month for the one-month option. Also remember that you want the person on the long side of this trade to have as short a time as possible to be right.
  • Give yourself as little time as possible to be wrong because your maximum risk is uncapped.

Appropriate Time Period to Trade

  • One month or less.

Selecting the Stock

  • Ideally, look for stocks where the OVI is persistently negative for at least the last few days.
  • Choose from stocks with adequate liquidity, preferably over 500,000 Average Daily Volume (ADV).
  • The stock should be rangebound or trending downward, and below a clearly identifiable area of resistance.

Selecting the Options

  • Choose options with adequate liquidity; open interest should be at least 100, preferably 500.
  • Strike—Look for OTM strikes above the current stock price.
  • Expiration—Give yourself as little time as possible to be wrong. Remember that your short position exposes you to uncapped risk, and that time decay accelerates exponentially (in your favor when you’re short) in the last month before expiration, so only short the option with a maximum of one month to expiration, preferably less.

1.2.3 Risk Profile

Maximum Risk

[Uncapped]

Maximum Reward

[Call premium]

Breakeven

[Call strike + call premium]

1.2.4 Greeks

1.2.5 Advantages and Disadvantages

Advantages

  • If done correctly, you can profit from falling or rangebound stocks in this way.
  • This is another type of income strategy.

Disadvantages

  • Uncapped risk potential if the stock rises.
  • A risky strategy that is difficult to recommend on its own.

1.2.6 Exiting the Trade

Exiting the Position

  • Buy back the options you sold or wait for the sold option to expire worthless (if the underlying stock falls and stays below the strike price) so that you can keep the entire premium.

Mitigating a Loss

  • Use the underlying asset or stock to determine where your stop loss should be placed.

1.2.7 Margin Collateral

  • The minimum requirement specified by the CBOE is 100% of the option proceeds, plus 10% of the share value. Many brokers specify 100% of the option proceeds, plus 20% of the share value.

1.2.8 Example

  • ABCD is trading at $28.20 on February 19, 2015.
  • Sell the March 2015 30.00 strike call for 0.90.

You Receive

Call premium

0.90

Maximum Risk

Uncapped

Maximum Reward

Call premium

0.90

Breakeven

Strike price + call premium

30.00 + 0.90 = 30.90

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