Playbook: Basis: the Short Call

Short (Naked) Call

The short call (or naked call) is one of the income strategies (generating income on a regular basis). Such strategies are typically short-term. The option premium is sold on a monthly basis.

The short call is the most dangerous of all options strategies since the risk is really unlimited, unlike the short put where the underlying can only go to $0.

The short call is the opposite of the short put.

A call is an option to buy. The buyer of the call option has a right to take delivery (call). The seller of the short call has the obligation to take the other side (sell the call).

So, selling/shorting a call means that the seller has the obligation to sell the right to call the put. The buyer of the put has a right to take delivery of the obligation (the put). In other words, when you sell a call, you have sold someone the right to buy. You may need some time to think this over :).

The position benefits from IV/IVR contraction and/or underlying price decreases below the strike.

Considerations

General

The reason for selecting this option strategy is that you expect the underlying to go down and remain above the strike and the option, therefore, being ‘OutThe Money’ (OTM: stock < breakeven). If the underlying is trading below the strike, it’s worthless. Paying more for an underlying that’s trading less than the strike is counter-intuitive.

These are the considerations for entering a short call:

• The expectation that underlying (stock, ETF, index, future) will go down or sidewards: the outlook is bearish.
• The underlying has just experienced a jolt upwards/increase.
• Implied Volatility (IV)/IVR (IV Rank) is high(>30), looking for options to increase in value over time.
• Adding negative delta to the portfolio.
• The maximum reward is limited (‘defined’) to the premium received (‘credit’).
• The risk is unlimited.
• Can be combined with another position to limit the risk.
• When you sell a (put or call) option, time (value) decay helps, so typically, expiration dates should be reasonably not too far away (ideally around 45 DTE, so in the last month before the option’s expiration); so the period of trade is one month or less.

Description

Set-Up

1. ‘ Sell to open’ (BTO) the call option ( in US 1 contract = 100 shares) at the call strike which is at 70% or greater PoP (which is somewhere in the 40-50 delta area)

Related Options Strategies

The long call is one of the four basic options strategies on which all other strategies are built, especially options strategies with long call legs: vertical, calendar, and diagonal spreads, condors, butterflies, reverse straddles and strangles, etc.

The Greeks

GREEK

+/-

Notes

Profile

Delta (direction speed)

–

Negative speed moves fastest around the strike price (delta -0.5) until it reaches -1. Delta = 0 when the option is deep OTM.

Gamma (acceleration)

–

Always negative and peaks inversely when Delta is at its fastest (steepest).
Gamma = 0 when the option id deep OTM or ITM (when Delta isn’t moving).

Theta (time decay)

+

Positive since time decay works helps the short call option.

Vega (volatility)

–

Volatility is hurting the position since higher volatility = higher option value. We’d rather have the option value decreasing.

Rho (interest)

–

Negative, higher interest rates harm the position.

Entry Rules

Profitable short calls require correctly selecting bullish underlyings AND good timing.

Criteria

• Acknowledge whether market sentiment allows trade.
• Check whether trade fits in portfolio allocation rules.
• Ensure stock meets all of your selection criteria (volume, open interest, ask-bid range, etc.).
• IV/IVR below 30%.
• Ensure the trend is upward/bullish.
• Ensure at least three of the technical momentum indicators are positive.
• Identify the clear areas of support and resistance.
• Make sure there are no major events (dividends, earnings) within 30 days of the expiry date.
• Profitability of Profit at selected strike: around 50%.
• Backtest (since 2006 and last 200 trades): at least $1.00 (average and mean) profit/day.

Technical Indicators Used

1. Trend = bearish
2. Support & Resistance = the underlying has just experienced a pullback/decline to clear support level
3. RSI = oversold
4. Bollinger Bands in combination with Keltner Squeeze: at the bottom and outside Keltner bands
5. ADX/DMI: increasing up and above 20
6. ATR low

P/L and Risk Profile

Net Position

Net credit , because you receive a premium to sell the call option.

Theoretical Profit

Time decay works positively with your sold call option. It will be eroding the value of your call every day, so all other things being equal, the call you sold will be declining in price every day, allowing you to buy it back for less than you bought it for unless the underlying stock has fallen, of course.

The reward is the credit, realized when the underlying price =< call strike.

If the underlying price decreases below the call put: expires worthless, and the seller can keep the premium.

Theoretical Risk/Risk Profile

As the stock price rises, the naked call moves into loss more and more quickly, particularly when the stock price is higher than the strike price.

The maximum risk is unlimited.

Breakeven

Underlying call strike + net call premium/credit.

Managing and Closing Position

Halfway to/Near Expiration

To better manage the position/mitigate losses: convert a profitable long call position into a long call debit spread: sell an OTM call against the long call for a credit => (equal to or higher than) the initial cost of the long call.

Rules for Managing/Adjusting Position

• If the underlying increases to the breakeven, the initial net premium/debit is covered (net even).
• If the underlying increases above breakeven, the buyer will profit.
• Set alerts on breakeven/predetermined targets.

Rules for Closing Position/Exiting the Trade

• Profitable positions are closed by buying the option (BTC) to close following your trading rules for the target profit % of the net premium/credit received to open the position.
• Buy the short put option before expiration, ideally not later than 21 DTE.
• Positions going against you (and below the stop loss you have set) are closed by buying the option (BTC) to close for a higher price than the net premium/debit paid to open the position.
• Alternatively, if the underlying is trading below the strike, and you want to take ownership of the shares at a cheaper strike price (since you obtained a premium when selling the put), you can let the shares be assigned to you at or before expiry.
• Manage multiple short puts by closing a portion of the position for profit, keeping some in place.

Additional Notes

Advantages

• Another way to earn income
• You can profit from falling or rangebound stocks.

Disadvantages

• Unlimited risk if the stock rises.
• Only for advanced traders.

Exercise/Assignment

Short calls can be assigned when the stock falls as shorted stock.