Why does shorting a call option have potential for unlimited loss?

Question

Referring to http://en.wikipedia.org/wiki/Option_(finance), for a short call:

If the stock price increases over the exercise price by more than the amount of the premium, the short will lose money, with the potential loss unlimited.

Assume the current stock price is $100, and I hold one stock. Then I sell a call option with a strike price of $100, expiring one year later, for a premium of $10.

So even if the stock price is $1000 a year later, I sell the stock at $100. I still earn the 10 bucks, so why am I going to have a loss? Even an unlimited loss? Is it about opportunity cost? I think it's unreasonable.

Answer 1

You are likely making an assumption that the "Short call" part of the article you refer to isn't making: that you own the underlying stock in the first place. Rather, selling short a call has two primary cases with considerably different risk profiles. When you short-sell (or "write") a call option on a stock, your position can either be:

• covered, which means you already own the underlying stock and will simply need to deliver it if you are assigned,

  or else

• uncovered (or naked), which means you do not own the underlying stock.

Writing a covered call can be a relatively conservative trade, while writing a naked call (if your broker were to permit such) can be extremely risky.

Consider: With an uncovered position, should you be assigned you will be required to first buy the underlying at the prevailing price in order to be able to fulfil your contractual obligation to sell/deliver the underlying to the exercising option holder for the [lower] contract exercise price. This is a very real cost — certainly not an opportunity cost.

Look a little further in the article you linked, to the Option strategies section, and you will see the covered call mentioned there. That's the kind of trade you describe in your example.

Answer 2

Well, if you are selling a call option, you have to obligation to sell that stock at the agreed price.

If today's stock price is $100 and you sell a call option for ... let's say $102 and stock 'shoots' up: then you buy the stock at $102 and sell it to the new price. You are out of the pocket [new price - $102] * 100 * number of contracts.

They say UNLIMITED because they think that stock could go up to infinite, which is unrealistic. But stocks cannot go too much up ...