Friday, September 7, 2012

Options 2.0 - Part 7. Basic Options Strategies; Short Call

The original column has been published (shortened ) in Dutch on September 7 at Telegraaf's / Goeroes / Opties 2.0 – deel 7. Basis Optiestrategie; Short Call

Basic options strategies
In my previous article of August 29th, "Basic Option Strategies; Long Put", you read all about the second basic option strategy, the Long Put.
Today I’m going to cover the third basic option strategy: the Short Call

Short Call (Selling a Call option)
A Short Call consists of a single leg; the Sale of a Call option.

A Short Call becomes attractive when you expect either a neutral movement and/or a decrease in the price of the underlying asset.
A Short Call can also be used to generate an extra return on your portfolio.

With a Short Call you’ll initially receive money. The investment amounts to the number of contracts that you sell x the Call option price x the contract size. If you sell 4 Call options for 5.50, then you’ll receive 4 * 5.50 * 100 = 2,200 Euros.

The Short Call strategy comes with a margin obligation. This means that you aren’t free to spend the received investment and that you must maintain a specific margin as security (to offset potential future losses) in addition. The Margin obligation is calculated and settled on a daily basis. And also intraday for the various banks and brokers.

Break-Even Point
You’ll reach the break-even point upon expiration if the price of the underlying asset is equal to the strike price of the Call option + the price that you received for the Call option. The Call option now has only an intrinsic and no longer a time value. Which is why your result is 0.

You’ll make a profit upon expiration if the price of the underlying asset is below the break-even point.

Maximum Profit
The maximum profit that can be achieved using a Short Call is limited to the Call Option premium received. Upon expiration, the Call has a value equal to the price of the underlying asset minus the strike price. If upon expiration, the price of the underlying asset is lower than the strike price of the Call option, then the Call option has no remaining intrinsic value. The Call option will expire at 0 and you’ll realise the maximum profit.

You’ll make a loss upon expiration if the price of the underlying asset is above the break-even point.

Maximum Loss (Risk)
Your maximum loss is unlimited! So the higher the price of the underlying asset, the greater the value of the Call option. And the greater your loss.

Price of the Underlying Asset (Delta) Influence
Negative. A Short Call has a negative Delta. A higher underlying asset price results in a higher Call option premium.

Remaining Maturity (Theta) Influence
Positive. Time works to your advantage with a Short Call strategy, because the remaining time value of the Call option reduces daily.

Volatility (Vega) Influence
Negative. A higher volatility indicates a greater remaining time value for the Call option and thus a higher Call option premium.

The advantage of the Short Call is that no price change is required to achieve a profit. For at-the-money and out-of-the-money Call options, a consistent underlying asset price is sufficient to achieve the maximum result.

The disadvantage of the Short Call is that the maximum loss is unlimited.

Suppose that we sell a Call option on the AEX-index with a strike price of 335.00 for a price of EUR 5.50. The AEX lists it at 335.77 at that moment in time
One call option provides an investment of -1 x 5.50 x 100 = - EUR 550.
The Call option premium includes a time value of 4.73 (= 86%). Thus 5.50 – intrinsic (= 335.77 – 335.00) = 5.50 – 0.77 = 4.73. So, upon expiration the AEX price may rise by 4.73 (from 335.77 to 340.50 = +1.4%) in order to reach the break-even point. If the price were to drop below 340.50 we would achieve a profit using this strategy. And if the price were to drop below 335.00 (= -0.2%), we would realise the maximum profit using this strategy.

Upon expiration the outcome would be as follows:

Short Call Graphical Simulation:
The x-axis shows the various price levels of the underlying asset.
The y-axis displays the (expected) result. The blue line indicates the expected result one month prior to expiration. The red line shows the result upon expiration.

The most common pitfall for private investors using Short Calls is to wait too long to close the position and take their profit or loss.

Options 2.0 ... Basic Options Strategy; Short Put
In this article we’ve taken a look at the third basic option strategy with a single leg; the Short Call. And we’ve covered how to use it and what the advantages and disadvantages are.
In the next article we’ll examine the fourth single leg options strategy; we’ll explore the Short Put.

Herbert Robijn is founder and director of FINODEX ( FINODEX develops innovative online investment tools for private equity and options investors. These cutting-edge tools allow investors to make a comprehensive market analysis, complex calculations and appropriate selections, at just the touch of a button.

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