Short Call
The Short Call strategy is utilized by the sophisticated, well financed, bearish investor. This trade entails extreme risk and should only be considered by investors that fully understand that risk. The Short Call is a "naked" position, whereby the investor does not own the underlying asset. By selling short Calls, the investor will receive the option premium and be subject to unlimited risk. This position also requires margin. Let's examine a short Call position.
BVF is trading at $20 and an investor is neutral to bearish. The investor decides to sell 10 BVF $20 Calls @ $3. The investor receives $3x10x100 =$3,000.00 in the account and this is the maximum return the investor can make. If the investor is correct, and BVF remains at or below $20 at expiration, the investor will keep the credit of $3,000.00 and the Calls will expire worthless from the account.
If on the other hand, the investor is incorrect and BVF moves up, the investor is subject to unlimited risk to the upside. For example, should BVF move to $30 at or before expiration, the investor will be subject to assignment. This means that the long Call holder, will exercise their right to buy BVF at $20, forcing the short Call seller to deliver stock at $20. The loss arises from the fact that the Call seller does not have the underlying stock and will have to go into the market and buy the stock at $30 (market price) and turn around and deliver it to the long Call buyer at $20. In this case, that would equate to a gross loss of $10,000.00. The actual loss the investor would sustain is the difference between the strike price ($20) less the market price ($30) less the option premium received ($3). This works out as $20-$30+$3= -$7 x 10 x 100 = -$7000.00. If BVF where to continue higher before expiration, the loss would continue to increase.
Strict discipline should be utilized if entering into short Calls. Should the trade move against the investor, the investor can "buy back" the short options they originally sold and any further loss potential is removed.
