THE TOOLS OF THE TRADE

THE SHORT CALL 

A short option position comes with obligations.  When the trader initiates a “sell to open” order he/she is obligated if the option is assigned, to sell shares at the strike price of the short option.  When selling calls, it is generally not wise to sell “naked” or uncovered positions because the obligation leaves the seller of the option with a theoretically unlimited risk.

The short call is most commonly used in conjunction with another investment instrument such as a long call in a spread position or in association with a long stock to form what is known as a “covered call”.   The short call when used with another trading instrument, be it a long stock or a long call, can reduce the cost basis of the aforementioned stock or call.  Many use the short call to create monthly cash flow in a long stock portfolio. 

However, it is important to realize that the short call creates some limitations in that its’ presence in tandem with a long stock will limit the upside potential of the stock position.  It does, however, provide a limited hedge to the downside. 

When selling an option, the premium for that option will appear immediately in the trader’s account and may be used for other investments.  It is important to know that even though the premium for selling the option is  in the trader’s account, the premium is not necessarily earned.  If the trader closes the position prior to expiration, that transaction may either result in a profit or loss depending upon the value of the option at that time. 

If the underlying moves swiftly toward the short call option strike yet does not breach the short call strike, the option will likely have increased in value and would cost more to “buy to close” than the premium that was received for the option initially.  If the option expires out of the money, the trader will keep the entire premium initially received when it was “sold to open.”

Study the graph and fully understand the risk and reward characteristics of the short call position.  We will review the short put next week.  Best Robin

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