When a speculator buys to open a call option (known as a "long call"), it's a bet the stock will rise above that strike price prior to expiration. Conversely, when a trader sells to open a call option (a "short call"), it's a bet the stock will stay at or below the strike price through expiration. In other words, this premium-selling strategy reveals neutral-to-bearish expectations for the underlying security.
However, this tactic isn't for everyone. When it's unaccompanied by a bought call at a higher strike (as in a short call spread) or an equivalent number of shares (as in a covered call), the short call is also known as a "naked call." That's because the trader is completely un-hedged, and therefore vulnerable to potentially steep losses. Meanwhile, the maximum reward on a short call is relatively modest.
Here's an in-depth look at a potential short call trade.
Stock XYZ gapped below the $25 level a few months ago as traders panned a poor earnings report, and the stock has since made several unsuccessful attempts to reclaim this level. You expect $25 to hold up as resistance during the near term, so you sell to open a 25-strike call on XYZ. The option is bid at 0.63; multiplied by 100 shares per contract, you'll collect $63 for selling the call.
However, you'll also have to shell out a margin requirement to your broker to enter the position. Due to the high risk involved in a short call (as described below), you'll be required to deposit a fixed amount into your margin account to cover potential losses. These requirements can vary from one firm to another, and they may also change with shifting market conditions -- so check with your broker to verify how much cash you'll need to secure your short call.
The $63 you collected for selling the call is your maximum potential gain on the position. This reward is yours to keep if XYZ should settle anywhere at or below $25 upon expiration, in which case the sold option can be left to expire worthless.
Breakeven, meanwhile, is equivalent to the strike price plus the net credit -- in this case, $25.63. However, if your call moves into the money, you'll need to buy (to close) the option to dodge assignment, thereby triggering another transaction fee.
The potential loss on a short call is theoretically unlimited, since there's no concrete ceiling to how high a stock can rise. Once the shares rally above $25.63, your losses will begin to add up.
So if XYZ surges to $30, the option will cost 4.37 (30 - 25.63) to buy back -- or $437, after accounting for 100 shares per contract. If the stock should climb all the way up to $45, you're staring down a loss of 19.37 (45 - 25.63), or $1,937 ... and so on.
Once you've entered a short call position, the best-case scenario is for implied volatility to decline. All other factors being equal, falling implied volatility will decrease the value of your sold option, making it cheaper to buy back.
As you've seen, the "naked" short call is a low-reward, high-risk strategy. While some speculators may be lured in by the idea of collecting a profit upfront, bear in mind that you also have to tie up a decent chunk of your investing capital in a margin account throughout the duration of the trade. For a lower-risk spin on this strategy, consider the short call spread.