Construction

It is the writing of call options.

When to use

When we believe that the price of the underline security will decline modestly or it will remain stable and the implied volatility is high. A deflation of implied volatility will produce profits even if the price of the underline remains stable. So, we have written the call in a higher price and we can buy it back at a lower price before expiration.

In case we believe that the underline security will decline very much, then it will be better to apply a different strategy because the short call imposes a limit on our possible profit.

The short call strategy is very dangerous because it has theoretically unlimited losses as long as the stock price is rising. That’s why brokers require the maximum possible margin for the opening of a short call position.

Loss/Profit at expiration

Maximum loss: Unlimited as long as the price of the underline is rising + commissions.

Maximum profit: Limited to the premium we earned – commissions.

Profit/Loss diagram

Below we can see the profit/loss diagram for the short call strategy. The strike price is $25 and the premium is $2.

Short call strategy example

In the daily chart of JPM stock (below) we can see that price is visiting a support level for the third time at point A (the first one is not shown for space reasons). After several ”touches” the support have been exhausted so we believe that soon a breakdown will occur. The implied volatility is relatively high and the market is also in a midterm downtrend which augments the possibilities of the breakdown. We can short sell calls with strike price $39 or $40 and close our position when the breakdown occurs or when the implied volatility deflates.

In case that the stock price will move upwards in contrast to our expectations, then we must think of closing the position because the short call strategy has theoretically unlimited losses (look at the INHX example in the page ”what is leverage”, for a better realization of the risk).