Short Call Option

The Short Call Option is the riskiest bearish strategy available to us. Instead of buying a put you sell a call. A truly bad idea, it makes short stock look like a relatively innocent endeavour.

This is a limited profit and unlimited risk trade. When I say unlimited I really mean it. It’s obvious the stock can’t go to infinity but a single short call can blow up our account!

You set it up by sending a sell order for 1 call options contract at your chosen strike. These are the scenarios suitable for a Short Call Option:

  1. Never
  2. You are absolutely certain what you’re doing and have a clear contingency plan

We can see that a 25% increase in the theoretical stock price will result in a loss of $1k:

short call option
Payoff at expiration of an at-the-money $50 strike call option in a theoretical stock trading for $50

Short Call Option Delta

The Delta depends on your bearish conviction. However, similar to the short put option we have to make sure we’re collecting enough premium. It’s the case with any short options strategy.

Remember that the risk is not just undefined, it’s unlimited. I’ll quote the example from the GME case. We sell the 70 strike call in GME for $3.76 while it’s trading for $40. Seems pretty harmless, right? 10 days later we’re down $288.24 or $28,824.

I could maybe argue that you just have to sit it out until the stock goes back to normal. However, this won’t happen if you have a small account because you’ll get a margin call and your position will be liquidated. Consequently, we’ll define unlimited risk as any single trade which can lead to a blown account.

It is almost compulsory to sell calls when the Implied Volatility rank is high because you’ll collect more premium and you’ll benefit from more time decay.

A long call has a positive Delta, therefore, your Short Call option has negative Delta ( -1 contract x (+20 Delta) = -20 Delta).

The Delta will become more negative when the share price goes up. Your P&L will be in the red. Therefore, an increase in the Delta towards 0 means that the stock is going down and your P&L will likely be in the green.

Gamma Risk

The Gamma, Vega and Theta sections are quite similar to the short put option. Therefore, I only changed the elements addressing short call particulars.

Whenever you sell any option, call or put, you are short Gamma. Therefore, it will compound losses if the underlying stock appreciates.

This happens because the Delta of the short call option is negative and will decrease more and more with each $1 increase in the share price. The person who bought the call from you will observe a Delta which becomes more positive and Gamma which becomes more positive.

For example, we have two 20 Delta options in different stocks. One of them has 3 Gamma while the other has 30. A $1 increase in the share price will decrease the short call option’s Delta to -23 and -50 respectively.

You can think about it in the following way. The call can’t have more than 100 Deltas. You sold 20 of them so another 80 are left on the table. However, even if you sold 90 Deltas you are still at a risk of unlimited loss because the option will continue to gain intrinsic value as the share price appreciates.

Gamma increases around 3 weeks prior to expiration and becomes the main loss factor. High Gamma means that a smaller move in the share price will cause a greater decrease in the Delta. Here is a visual of the Gamma increase:

Gamma risk
The graph includes call and put options. DTE 1 means 365 days, thus 0.1 equals 36.5 days.

This is easily managed by closing the position around 20 days prior to expiration.

Vega

Short Call options go hand in hand with a high IV rank. A low IV rank will result in inadequate premium to substantiate the risk.

The downside is that you are short Vega. So whenever you sell a call you make a stand that the implied volatility is overstated and you anticipate a decrease.

This will lead to a Delta and Vega driven profit if both the stock and volatility comply. In the mean time you benefit from time decay.

Vega risk

However, we’re directionally short the stock and we know that volatility increases as the share price decreases. So you may end up in a situation where your directional assumption is correct but the volatility went crazy and your P&L is in the red.

It will remain to be seen if the stock stabilises at the lower price level or move against you.

Then you’ve got Vanna, a second-order derivative, which adds insult to injury. It’s the Delta-Vega relationship which will cause your Delta to swell further. So we could end up with a Vega and Vanna driven paper loss.

The easiest way to explain this is by thinking what happens when volatility expands. You’ll anticipate a wider range in the stock’s expected move. Thus, your call will have a higher chance of ending in the money.

You can see that the ‘double whammy’ is in reality a ‘triple whammy’.

Volatility expands quickly so you’ll be hurt less if it was already high when you sold the call. The problem is that you may sell a call when the stock is down and get whipsawed when it recovers.

I think that sometimes people don’t take Vega seriously enough so here’s an example. You sold a call with a Vega of 5. It doesn’t sound that much right? Maybe but you’re looking at a paper loss of $75 if the implied volatility goes up by 15%. That’s before taking into consideration Delta and Vanna.

You need to be aware that sometimes the volatility goes up as the share price goes up. It’s less common but it’s happened to me often enough to notice it.

Theta

Time decay is your friend. Even if nothing else changes after you sell a put Theta will add a small bit to your P&L every single day, more or less.

You just sit there and wait until you collect your premium. That’s another reason to aim for high IV rank, it means high Theta, the more the merrier. The price of the option will be higher so inevitably it has to lose more money to time decay should everything else remain equal.

Similar to Delta and Vega Theta has higher-order derivatives too and this time all of them work in your favour.

The second-order ones, Charm and DvegaDtime, gradually annihilate your Delta and Vega exposure respectively. You only need to wait for the magic to happen.

Your Gamma will bleed too since it’s a derivative of Delta. I know that it sounds counterintuitive since I said that Gamma increases prior to expiration. How can an athlete run faster with a bleeding leg?

Let’s say you have a 30 day 5 Delta option with 1 Gamma. If you go to the 16 day expiration you’ll notice that the same strike has 2 Delta and 1 Gamma while the 5 Delta has 2 Gamma.

So the Gamma has doubled but the odds of the option ending in the money are pretty slim. It doesn’t matter because you’ll be closing the position prior to the Gamma increase. There’s no point in maintaining a short call risk exposure over $0.20 worth of premium. You can trade something else, make your money work for you.

You need to be aware that Theta is a theoretical construct and the time decay won’t occur in a linear fashion. It all depends on the market conditions.

Short Call Option Management

You can do anything you want but my personal understanding of risk implies a more aggressive management approach compared to a short put.

Winners

Close the position at 50% of max profit or any other arbitrary amount, like 70% or 30%. The logic behind this is fairly simple.

Imagine a $1.20 call with 40 days to expiration. If it goes down to $0.80 in 3 days you’ve made over 10% of the max profit per day. You can close it and trade something different rather than wait another 37 days for the remaining 70%.

This reduces the exposure and mitigates some of the upside risk.

Losers

You can’t sell options without getting used to the fact that you’ll see red in your P&L at one point or another. So when you do don’t freak out, check what’s going on.

If the IV has gone up and the share price is nowhere near your strike you just wait. It may cool off in a few days and everything will go back to normal.

Another scenario is when the share price increases.

You can either wait a bit if you think that the stock will tank, roll the option to the next expiration cycle or reverse Gamma scalp the position. If you’re rolling make sure that you collect additional premium.

Beware that whenever you roll a losing position you lock in a loss. You are closing one trade at a loss and opening a brand new one. So you need to be certain that this is your best option.

The second approach is to leave it alone. This is most suitable if you don’t care about your P&L for some reason. I’d suggest to do some back-testing before you implement this approach but whatever results you get take them with a pinch of salt.

Short Call option Delta hedging

Trade like a market maker. You can’t because you don’t have an inventory and a large pile of cash sitting around. Otherwise, you’d only be reading this for entertainment with regard to the views of retail traders.

Let’s not be that negative. You can add a static or a dynamic Delta hedge to your position with either static or dynamic Delta. Don’t be discouraged if you’ve got no idea what I’m talking about. It will sink in eventually.

Static hedging

This is very simple, you short a 30 Delta call, you buy 30 shares and you’re delta neutral for the time being. Mathematically -30 + 30 = 0 Delta.

It’s most unfortunate that the share price fluctuates so yes the shares will absorb some of your losses but the same will happen to your wins. I don’t see any point in doing this as a retail trader. There are Delta neutral strategies if you fancy one.

Dynamic hedging

We can adjust the Delta dynamically. This makes more sense because it is congruent with the price action.

With stock a.k.a. static Delta

If we use the example above and our Delta goes down to -40 we just buy another 10 shares. It works a bit as if it was a covered call only that we’re covering the call as we go along.

Once the Delta of the options contract reaches some threshold, like say -60, -75, -80 or anything you set your eyes on, you just cover the whole call with a total of 100 shares. The important part is to make sure you bought the shares for an average cost around the call strike. Mathematically short the $3.70 50 strike call and buy 100 shares at an average cost of $51 equals a profit of $3.70 – $1 = $2.70 or $270.

It sounds simple but it’s not, at least not in a practical sense. This will work if the stock appreciates gradually. It won’t work for a kangaroo stock because you’ll keep buying and selling shares at a loss. Remember that you buy them high and sell low.

Imagine that we have a Delta neutral position of 40 shares and -40 Deltas, however, the stock tanks and now we have -20 Delta. We sell 20 shares at a loss only to see the stock gap up the next day to bring our Delta back to -30. Then we buy 10 shares for a higher price. Repeat that long enough and you’re broke.

With options a.k.a. dynamic Delta

Now we’re getting to the messy part. We can achieve something similar to the above with options. However, their Delta fluctuates just as much as the share price if not more.

So we’ve got out -30 Delta Short Call option and now our Delta’s -40. What can we do on the cheap? I’m saying this because shares are expensive, we need cheap Deltas.

We can buy a higher or lower strike call but this turns the strategy in a call spread. Both spreads are suboptimal because you end up either paying more or collecting less for the spread. So that doesn’t make any sense unless you’re desperate.

Another way to go about it is to sell a put, like a 20 Delta, and turn the strategy into an asymmetric strangle. This is somewhat better as we don’t use a lot of margin since the stock can’t go up and down simultaneously. However, it brings a host of other problems.

The first one is that you convert the strategy from bearish to neutral. Then you’ll lose the Delta hedge if the stock keeps going up because the put will lose its Delta. You probably won’t collect a decent premium for the put because volatility is likely to decrease as the share price is increasing. Finally, you can get whipsawed on the way down and now you have to worry about the put leg.

However, you collect some premium from the put to mitigate the losses.

Conclusion

There is no predictable way of defending a single Short Call option as a retail trader other than not selling one in first place. I know this is not helpful and sounds a bit negative but it is the truth. Even a market maker is never perfectly hedged.

You’re likely better off trading a different bearish strategy, a vertical spread for example. Having said that you’ve probably heard of traders who do it successfully. There are many of them but you have to acknowledge that these individuals are very experienced.