A 'Call' option is a financial contract that grants the buyer the right, but not the obligation, to purchase a stock at a specified price within a particular timeframe. Typically, investors acquire a 'Call' option when they anticipate a rise in the underlying stock/index.
Conversely, when they anticipate a decline in the underlying stock/index, investors adopt the opposite approach by selling or shorting a 'Call' option. This position comes with a limited profit potential but exposes the seller to the possibility of significant losses in the event of substantial advances in underlying prices. While it is a straightforward strategy to execute, it carries inherent risks, especially for the seller of the Call, who is exposed to unlimited risk.
When to use: This strategy is suitable when an investor is exceptionally aggressive and holds a strongly bearish outlook for the Stock/Index.
Risk: Unlimited
Reward: Limited to the premium amount received.
Break-even Point: Strike price + premium.
To illustrate, consider the following example:
Mr. XYZ holds a bearish view on Nifty, anticipating a decline. Consequently, he sells or shorts a Call option with a strike price of ₹2,600 at a premium of ₹154 when the current Nifty stands at 2,694. If Nifty remains at 2,600 or below, the Call option will not be exercised by the buyer, allowing Mr. XYZ to retain the entire premium of ₹154.
Analysis: This strategy is typically employed when an investor is aggressively anticipating a price decline and not an increase. It involves significant risk, as the short call incurs losses more rapidly with each rise in the Stock price/Index, and losses can be substantial if the Stock price/Index falls below the strike price. Termed as Short Naked Call, this strategy is deemed risky as the investor does not own the underlying stock that is being shorted.