What it means
A call option gives its buyer the right, but not the duty, to buy an asset at a fixed strike price before a set date. The seller of that option is on the other side.
In exchange for the premium, the seller must hand over the asset at the strike price if the buyer exercises, and this is the short call. A short call is bearish or neutral.
The seller hopes the share price stays below the strike price so that the option expires worthless and the premium is kept. The maximum profit is the premium received, and it is earned in full only if the price is at or below the strike at expiry.
There are two main versions. In a covered call, the seller already owns the shares, so if the option is exercised the shares are simply delivered, and the risk is giving up gains above the strike.
In a naked or uncovered call, the seller does not own the shares and would have to buy them at the market price to deliver them, which exposes the seller to unlimited losses. Investors use covered calls to earn extra income on shares they already hold, accepting a cap on their upside.
Traders use naked calls to profit from a view that a price will not rise, but they need substantial margin and carry high risk. Brokers apply strict approval levels for selling uncovered options.
The nuance is that time works in the seller's favour. An option loses value as expiry approaches, an effect called time decay, so a short call can earn money even if the share price barely moves.
Early exercise is also possible, particularly before dividends, so sellers should be ready to deliver the shares.
In practice
Real-world examples.
Example
An investor owns 500 shares of a steady dividend-paying company and sells covered calls against them every quarter. The premiums add a small additional income, though she accepts that she might have to sell the shares if the price jumps.
Example
A trader believes a volatile technology share is overvalued and sells a call with a strike well above the current price. If the share stays below the strike, he keeps the premium, but he sets a rule to close the position if the share price approaches the strike.
Example
A corporate treasury team holds shares received in a business sale and does not expect them to rise soon. It writes calls on part of the holding to earn premium income, with the board's approval of the policy.
Formula
Calculation
Profit per share at expiry = premium received - maximum of (share price at expiry - strike price, 0)
Breakeven price = strike price + premium received
Suppose an investor sells one call contract covering 100 shares with a strike of $50 and receives a premium of $3 per share, or $300. The maximum profit is $300 if the share is at or below $50 at expiry. The breakeven price is 50 + 3 = $53. If the share is at $55 at expiry, the profit per share is 3 - (55 - 50) = -$2, so the total result is 100 x -2 = -$200 for an uncovered call.Case study
Seen in the real world.
Oakmont Family Office is an illustrative, fictional investor that held 10,000 shares of Delta Logistics, a fictional company trading at $40. It sold covered calls with a strike of $45 and received a premium of $2 per share, a total of $20,000.
At expiry the share price was $47. The options were exercised, so the office delivered its shares at $45 and kept the $2 premium, receiving an effective $47 per share, which equals the market price at that moment. It gave up any gains above $47 but had earned $20,000 along the way.
Had the office sold the calls without owning the shares, it would have had to buy 10,000 shares at $47 and deliver them at $45, a loss of $20,000 on the shares, offsetting the premium it collected. The illustrative lesson was that covering the position changes a potentially large risk into a capped upside.
Watch out
Common mistakes.
- Treating the premium as free money, when the seller takes on a potentially large obligation in return for it.
- Selling uncovered calls without enough margin or a plan for a sharp price rise.
- Forgetting that options can be exercised early, particularly around dividend dates.
Questions
People also ask.
What is the maximum loss on a short call?
For a covered call the risk is giving up gains above the strike, while for an uncovered call the loss is theoretically unlimited because the share price can keep rising.
What is the difference between a short call and a long call?
A long call is bought and gives the right to buy shares, while a short call is sold and creates the obligation to sell them if exercised.
When does a short call make money?
It makes money when the share price stays below the strike plus premium at expiry, and the option loses value through time decay.
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