why short call is a liability? like, management, liability, example, written

Wendy01

I would like to know why short a call is a liability.
In the derivative application for risk management study session the concept is written on the Schweser notes.

When short a call, get a premium for example $ 50.
Call seller has now U$ 20, then why it is a liability?

If the call in the money, say + 100 at expiration then the payoff to the seller is - 100 & profit -80
If the call is out of money then the payoff to seller is 0 & profit +20

with this trait, how a premium on short call seens as liability? when in the money, the premium 20 protected the loss for amount of 20 (loss 100 to 80)

jmh530

Short call is a liability because the short has an obligation to deliver when the long "calls" for th security...

Iginla2011

Think about it in terms of credit risk...If exercise you owe the other party.

Darien

Good point, no credit risk but higher market risk and liquidity risk.

mik82

what is the higher market risk and liquidity risk for a short side on the call?

CP

zwjy

The loss of call short position is unlimited. A market risk, please correct me if I'm wrong.

A [American] Call could be assigned if it's deep in the money and closer to the maturity date. Call buyers do not bear a risk like this.

It's just my thought, not completed SS15 yet. Derivatives are used to hedge various risks and the derivatives market "allocate" the risks to the parties who know how to manage them. Overall, it's more than a zero-sum game since each party then can focus on its expertise. The overall wealth increases.



Edited 1 time(s). Last edit at Thursday, March 31, 2011 at 12:33PM by deriv108.

Windjam

you sold the call. you earned your premium.
you are going to renege on the deal and not deliver the contract. (which means prices of the underlying has actually gone up - which is why the buyer has exercised the right to use the option).

not sure about market risk and/or liquidity risk in this situation. we are talking about the call OPTION not the underlying itself. There is however a credit risk to the long party (which is not unfounded since you are, as the short, going to renege on fulfilling the obligation). Short call thus becomes a liability as well.

CP

Colum

There is definitaly credit risk to the long as the short could always renege - that's the definition of credit risk right there. However, I'm not sure there is NO mkt or liquidity risk in options trading.

For mkt risk you still hold an asset that can fluctuate in price, really the issue would lie in whether you intend to sell it(or unwind the position) or let it expire. If you unwind the position you are certainly at the mercy of the mkt prices of the option available at that time. I'm not sure you can exclude mkt risk based on intent (Bonds still have mkt risk whether you plan on holding till maturity or just trying to capture a narrowing spread return)

For liquidity risk, I'm sure some options are easier to sell in the market than others. If you are planning to unwind your position you may not be able to find a counterparty in time and end up with an assignment you didn't want. (this may be why you reneged - bringing the credit risk to a reality - because your option was too illiquid to unwind!)


Just a couple of thoughts. Anyone agree?

former

Thanks. I'll keep the discussion relevant to the exam.

Options is asymmetric -- naked call is much risker than buying call. The financial risks are Market, Credit and Liquidity risks. That's my basic thinking.

The call writer bears no Credit Risk, I have no problem with it. What does the largest risk a call option writer take?

bpdulog

the credit call can be unlimited as the profit is not limited