What is a Short Call Strategy?

Overview

When you buy a Call you are hoping that the underlying stock/index would rise. When you expect the underlying stock/index to fall you do the opposite. When an investor is very bearish about a stock/index and expects the prices to fall, he can sell Call options. This position offers limited profit potential and the possibility of large losses on big advances in underlying prices. Although easy to execute, short call is a risky strategy because the seller of the call is exposed to unlimited risk.

A Call options means an Option to buy. Buying a Call option means an investor expects the underlying price of a stock/index to rise in the future. Selling a Call option is just the opposite. Here, the seller of the option feels the underlying price of the stock/index is set to fall in the future.

When to use: Investor is very aggressive and he is very bearish about the stock/index.

Risk: Unlimited.

Reward: Limited to the amount of premium

Break-even Point: Strike price +premium

Example

Mr. XYZ is bearish about Nifty and expects it to fall. He sells a Call option at a strike price of Rs. 2500 at a premium of Rs. 154, when the current Nifty is at 2694. If the Nifty stays at 2600 or below, the Call option will not be exercised by the buyer of the Call and Mr. XYZ can retain the entire premium of Rs. 154.

Analysis

This strategy is used when an investor is very aggressive and has a strong expectation of a price fall (and certainly not a price rise). This is a risky strategy since as the stock price/index rises, the short call loses money more and more quickly and losses can be significant if the stock price/index falls below the strike price. Since the investor does not own the underlying stock that he is sorting this strategy is also called Short Naked Call.

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