Definition
Shorting the CALL is opposite to Long CALL. Long CALL is supposed to be one of the simplest Options Strategy but Shorting the CALL is very complicated.
When you Sell the CALL, you have Obligation to sell the Stock at the Strike Price on or before the expiration date to the buyer of the CALL. Even if the stock is trading significantly above the strike price, you have the commitment to sell it at the strike price. If traded wrongly, you may suffer huge loss..
The Naked CALL is written when the Writer or Seller of the CALL doesn’t own the underlying stock. If the Seller owns the underlying stock, it is called Covered CALL.
Since this has significant risks, only experts should run this. Most of the Brokerage firms have strict requirements for letting the trader sell Naked CALLs.
When to run the strategy
The owner of the Stock is expecting the Stock to stay below the Strike Price (or below the Strike price plus premium) before the Expiration date.
Benefits of strategy
· You can earn the premium just by making the commitment to sell the stock at strike price.
Transactions
· You Sell the CALL at the Strike Price (S) (say $110) and receive the premium (P) (say $7).
Max Profit
The Max Profit is Capped at the Premium received for selling the CALL.
Example for Potential profit:
Strike Price: $110
Stock Price at Expiration <110
Premium: $7
So Profit = $7 (Premium received)
Potential and Max Loss
Potential Loss is
(Strike price of option + Premium) - Stock Price at Expiration
Example,
Strike price of CALL $110
Stock Price at Expiration (say): $200
Premium: $7
So Potential Loss= ($110 + $7) - $200 = $83
There is no limit to the Loss
Max loss = Premium paid for the CALL
Breakeven point
This occurs when the value of the stock is equal to Strike Price plus premium paid.
Example:
Strike Price for CALL- $110
Premium paid - $7
So Stock price at breakeven point should be (110 +7) = $117
At Expiration
Ø If the Stock price is above Strike price:
The seller will be obligated to sell the stock at the Strike Price. Since the Seller of the CALL doesn’t have the underlying stock, it would result in a Short Position in his portfolio.
Note: The Seller can close the CALL before the expiration by buying it in the Options market. Also, the Seller of the CALL can buy the stock which would convert the Naked CALL position to Covered call.
Ø If the Stock price is below Strike price:
The CALL Option expires worthless.
The Premium received for selling the CALL is all yours to keep.
Who should trade this?
Since this strategy has very high risk and if not traded properly, you can lose all your investment, it should not be traded by beginners.
Beginners - No
Intermediates - No
Experts - Yes
Masters - Yes
Time decay
Ø Time Decay works in your favor.
Ø As Expiration date approaches, the time value of Option will reduce.
Ø The time values reduce to 0 on the day of Expiration.
Points to consider
Ø Exit strategy: If Stock gains substantially, you may want to close the CALL position by buying the CALL or buying the underlying stock/ETF.
Ø Brokerage Cost: Always consider brokerage cost when making a trade.
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