The index short call strategy is a bearish strategy designed to earn from the premiums for selling the index call options with the hope that they expire worthless.
|Index Short Call Construction|
|Sell 1 ATM Index Call|
The options trader employing the index short call strategy expects the underlying index level to be below the call strike price on option expiration date.
Maximum profit is limited to the premiums received for selling the index calls.
The formula for calculating maximum profit is given below:
As the index level could rise dramatically, there is virtually no limit to the loss sustainable should the index level rallies explosively.
The formula for calculating loss is given below:
The underlier price at which break-even is achieved for the index short call position can be calculated using the following formula.
XYZ Index is a broad based index representative of the entire stock market and its value in June is 400. Believing that the broader market will fall moderately in the near future, an options trader sells a six-month XYZ index call with a strike price of $400 expiring in December for a quoted price of $4.50 per contract. With a contract multiplier of $100, the premiums received for selling the index call option comes to $450.
Suppose XYZ Index rose to 420 in December and the DEC 400 XYZ index call expires in-the-money. At settlement value of 420, the DEC 400 XYZ index call option will possess an intrinsic value of $20 and upon assignment of this option, the trader is required to pay a settlement amount of $2000 ($20 x $100 contract multiplier). Taking into account the premium received for selling the index call option, which is $450, the trader's net loss comes to $1550.
Suppose XYZ Index went down to 380 in December and the DEC 400 XYZ index call expires out-of-the-money. At settlement value of 380, the DEC 400 XYZ index call option will expire worthless with zero intrinsic value. The trader's net profit is therefore equal to the amount received for selling the index call option which is $450.
For ease of understanding, the calculations depicted in the above examples did not take into account commission charges as they are relatively small amounts (typically around $10 to $20) and varies across option brokerages.
However, for active traders, commissions can eat up a sizable portion of their profits in the long run. If you trade options actively, it is wise to look for a low commissions broker. Traders who trade large number of contracts in each trade should check out OptionsHouse.com as they offer a low fee of only $0.15 per contract (+$4.95 per trade).
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