| Home | My photos | Forex | My trading | Contacts |
|
|
You Can't Become Rich In Your Pocket Until You Become Rich In Your Mind | ||||
|
If the underlying stock stays below the strike price of the short call until the options expiration, the option expires worthless and the trader gets to keep the credit receivedSHORT CALL In a short call trade, you are selling call options on futures or stock contracts. This strategy is placed when you expect the price of the underlying instrument to fall. If you want to go short a call, your risk curve would look like the graph in Figure 4.10. If you want to short a stock, your risk curve would fall from the upper left-hand corner to the lower right-hand corner (see Figure 4.10). Notice how the horizontal line slants upward from right to left, providing insight as to its bearish nature. When the underlying instruments price falls, you make money; when it rises, you lose money. This strategy provides limited profit potential with unlimited risk. It is often used to get high leverage on an underlying security that you expect to decrease in price. Selling a call enables traders to profit from a decrease in the underlying market. If the underlying stock stays below the strike price of the short call until the options expiration, the option expires worthless and the trader gets to keep the credit received. But if the price of the underlying stock rises above the short call strike price before expiration, the short option will be assigned to an option buyer. A call buyer (as discussed in the previous section on long calls) has the right to buy the underlying asset at the call strike price at any time before expiration by exercising the call. If the assigned call buyer exercises the option, the option seller is obligated to deliver 100 shares of the underlying stock to the option buyer at the short call strike price. This entails buying the underlying stock at the higher price and delivering it to the option buyer at the lower price. The difference between these two prices constitutes the sellers loss and the buyers open position profit. This can be a huge loss in fast markets, which is why we never recommend selling short, or naked, options. Selling naked calls is not allowed by many brokerages. Some may require you to have at least $50,000 as a margin deposit. This speaks volumes about just how risky this strategy can be. However, since a short call is very useful in hedging and combination options strategies, it is important to understand its basic properties. In the case of selling options, be advised that you will initially receive money into your account in the form of a credit. This is the premium for which you sold the option. This strategy is used to generate income from the short sale of an option, since it provides immediate premium to the seller. In addition, its best to short calls when the implied volatility of the option is high; that way, you maximize the premium received. This is vital since the profit on a short call is limited to the premium received, and the position has an unlimited upside risk. As you can see by looking at the risk graph in Figure 4.10, this is a very risky strategy because it leaves the trader completely unprotected. Short Call Mechanics Lets create an example that shows the trader going short 1 Jan XYZ 50 Call @ 5.00. The trader collected $500 (5 100 = 500) minus commissions for this trade. The maximum reward is limited to the credit the trader receives at the trades initiation. Conversely, the risk on this trade is unlimited as the price of the underlying asset rises above the breakeven. The breakeven of a short call equals the strike price of the call option plus the call premium. In this trade, the breakeven at expiration is 55: (50 + 5 = 55). As the market drops, the position increases until it hits the maximum credit (i.e., the amount of premium taken in for the call. Please note that a short call comes with unlimited risk to the upside. It is very important that you learn how to create covered positions (i.e., sell an option and buy an option) to limit your risk and protect against unlimited loss. Figure 4.10 shows the risk profile of the short call position. When the underlying stock reaches a price of 50, the positions profit hits a maximum of $500 (the credit received). The calls potential loss is unlimited and continues to increase as the price of the underlying asset rises above the $55 breakeven. If the market price of the underlying asset doesnt rise, you get to keep the credit. However, this is the most that can be made on the trade. Exiting the Position A short call strategy offers three distinct exit scenarios. Each scenario primarily depends on the movement of the underlying shares. XYZ falls below the call strike price (50): This is the best exit strat egy. The call expires worthless at expiration. This means you get to keep the premium, which is the maximum profit on a short call position. XYZ rises above the call strike price (50): The call will be as signed to a call holder. In this scenario, the call seller is obligated to deliver 100 shares of XYZ at $50 per share to the assigned option holder by purchasing 100 shares of XYZ at the current market price. The difference between the current market price and the delivery price of $50 a share constitutes the loss (minus the credit of $500 initially received for shorting the call). XYZ starts to rise above the breakeven (55): You may want to offset the position by purchasing a call option with the same strike price and expiration to exit the trade because assignment becomes increasingly likely once the time value of an option falls below 1/4 point. Short Call Case Study When looking for short call candidates, what we want to see is a stock that has run into resistance and that is expected to move lower before option expiration. Since we are selling the call, we also want to use time decay to our advantage by selling front month options. Lastly, we are looking for a stock that has options that are showing high implied volatility (IV) compared to the past. The higher the IV, the larger the premium we receive up front. Lets look at a real-world example for a short call. In late May 2003, we could have run a search for stocks that had options showing high implied volatility. One stock that would have shown up Short Call Strategy: Sell a call option. Market Opportunity: Look for a bearish or stable market where you anticipate a fall in the price of the underlying below the breakeven. Maximum Risk: Unlimited as the stock price rises above the breakeven. Maximum Profit: Limited to the credit received from the call option premium. Breakeven: Call strike price + call option premium. Margin: Required. Amount subject to brokers discretion. was Northrop Grumman (NOC). On May 26, NOC spiked higher, but ran into resistance near $90. By entering a short call, we have unlimited risk to the upside. This means that if the stock moves sharply higher, we have to come up with the money to cover the call. However, we get a credit immediately from the sale of the call, though margin will be needed. In our example, NOC was at $87.96 as of the close of trading on May 27. At that time, we could have sold the June 90 call for $1.10, or $110 per contract. In this case, our maximum risk is unlimited as the stock rises and our maximum profit is the initial credit received. Our breakeven point is found by adding the credit we received (1.10) to the strike price of 90: (1.10 + 90 = 91.10). Thus, the breakeven point as of expiration is at $91.10. Short Call Case Study Strategy: With the stock trading near $88 a share on May 27, 2003, sell 10 June 90 calls @ 1.10 and hold until expiration. Market Opportunity: NOC has run into resistance and looks like it is in a downtrend. Maximum Risk: Unlimited to the upside above the breakeven. Maximum Profit: Net credit initially received. In this case, $1,110: ($110 10 = $1,110). Breakeven: Strike price + call option credit. In this case, 91.10: (90 + 1.10). Margin: Extensive. is small when compared to the loss area. This occurs because the trade has unlimited risk as the stock rises. For most traders, this type of trade is too risky to undertake and it requires a lot of capital to be held in margin. Nonetheless, for the trader who has the funds and uses appropriate money management, a short call can be profitable. In our example, shares of NOC remained below $90 all the way through June expiration on June 20. In fact, the stock was making a move higher when expiration hit, but this trade still would have closed with a maximum profit of $110 per contract. |
|
|||||||||||||||
Previous Issues
|
| ©2007 Olesia | Home • My photos • Forex • News • My trading • Contacts |