Intro to Alternative Option Trading - Short Call Option
- Written by Carley Garner
Short Call Option
Why you would use them?
- If you believe that the market is going down, bearish
- The strength of your belief determines what strike prices you should sell
- Sell out-of-the-money options (higher strike prices) if you believe prices are not going up
- Sell at-the-money options (at current price) if you strongly believe prices are not going up (this isn't a recommended strategy due to the aggressive nature)
- The potential profit is limited to the premium collected minus commission and fees
- Your reverse break even point at expiration equals strike price plus the premium collected
- Reverse Break Even = Strike Price + Premium Collected – Commissions and Fees
- The maximum profit occurs if the market is below the strike price at expiration
What is the Risk?
- Exposes trader to unlimited risk; thus, these positions need to be watched closely
- Your losses increase if the market rises faster than the time decay erodes the option value
- The market trading above the reverse break even is equivalent to being short the futures contract
- At expiration your losses increase by one point for each point market moves above the reverse breakeven point
This trade was recommended on The Stock Index Report written by myself and published daily by DeCarley Trading on August 8th. While the recommendation was aimed at those trading the full sized S&P, an e-mini trader could have executed a similar trade with less profit potential and less inherent risk.
The original recommendation called for traders to sell the September S&P 500 1390 call option for $4 in premium or better ($4 in premium is equivalent to $1,000) and would have been filled on the 11th of August at or near the premium requested. In this hypothetical example, we will use a value of $4.2 simply because that is the Black and Sholes value assigned by our charting software.
In figure 1, you can see that although the order was placed on the 8th of August, it took a substantial rally in order to get filled. Patience such as this can lead to missing trades but will also help you to avoid premature entry and potential disaster should the market see a spike in volatility.
As you delve into this type of trading further, you will see that the same short option that limits your profit potential when things go right will cushion the blow when things go wrong. I strongly believe that if constructed properly and careful consideration is given to measures of volatility, a swing trading strategy using options provides traders with an aggressive vehicle that arguably provides better odds of success to a trader than an outright futures position.