Short Call

Underlying Strategy

Bearish or Neutral

When a trader is bearish on the instrument, or is expecting the instrument to have low movement to the upside.

Methodology

The trader shorts a Call option of the strike price, assuming that the instrument shall expire at or below the strike price at the time of its expiry.

Risk Profile:

This is a highly risky setup as the loss could be unlimited and the profit potential is limited.

However the probability of successful trades is more in selling OTM options.

Margin requirements are high for this strategy.

Calculations:

Max Potential Profit: Net premium received.

When: The stock is below the strike price at the time of expiry..

Max Potential Loss: Unlimited.

When: The stock crosses the strike price to the upside. 

Breakeven at expiration: Strike Price+Cost of the CE

Impact with passage of time

The CE price reduces with the passage of time, assuming the instrument price remains constant. Hence time decay works in favour of this strategy.

Illustration 

The trader has an expectation that Reliance had made an extreme up move and its time that its stock price would make a fall.

The trader has a view that either Reliance wont move upwards and remain neutral or make a bearish turn in the near future.

In order to take advantage of the neutral/bearish move , he decides to short an OTM CE of   strike price 1400, since he believes at the time of expiry Reliance would close below that price.

Note that this strategy has a limited profit but unlimited loss, so the trader should put up a higher margin in order to place the trade.

The CE of 1400 strike price is trading at 32.7. By shorting the CE, the trader gets a net premium of (32.7)*LotSize=32..7*500=Rs.16350. This is the maximum profit of the trader in case the stock price expires below the strike price.

The breakeven point for the strategy is at

(Strike Price+premium)=1400+32.7=1432.7.

Hence net loss would occur Reliance closes above 1432.7 at the time of expiry.

Scenarios

Stock closes at Rs.1400.

Profit= (Net premium received)*Lot Size

Value of the CE will be 0

Hence Profit=(32.7)*500

=Rs.16350

Stock Closes at Rs. 1390

Profit=(Net Premium received)*Lot Size

Value of the CE will be 0

Hence Profit=(32.7)*500

Rs.16350

Stock closes at Rs. 1420

Value of CE will be 20

Profit=(Premium received-(Stock Price-Strike Price))*Lot Size

=(32.7-(1420-1400))*500

Rs.6350

Stock closes at Rs. 1450

Value of CE will be 50

Profit/Loss=(Premium received-(Stock Price-Strike Price))*Lot Size

=(32.7-(1450-1400))*LotSize

Loss =Rs. 8650