Call options are agreements between a buyer and a seller that give the buyer (or option holder) the right, but not the obligation, to buy a security at a predetermined price within a specified timeframe. This article focuses on the naked call options strategy, a type of call option that requires advanced trading skills that you can apply to possibly gain from stock price fluctuations. Naked call strategy comes with great risk.
This article delves into the definition and workings of a naked call as well as its pros and cons and provides illustrative instances.
What Is a Naked Call?
A naked call (or uncovered call) is a call options strategy where an investor sells (or writes) a call option without owning the underlying stock. Unlike the covered call option strategy, where the investor has the security of owning the underlying stock or security, this strategy is considered a high-risk strategy because of the potentially unlimited losses the option seller may suffer if the stock's price rises.
How Do Naked Calls Work?
Naked calls work by selling call options on a stock without actually owning the underlying shares. The option seller or writer hopes that the stock price will decrease or stay below the option's strike price, allowing them to keep the option premium received from the buyer. But the buyer can exercise the option if the price rises above the strike price, resulting in a p loss for the options seller.
Writing a Naked Call
When writing a naked call, the option seller sells a call option contract on a stock in exchange for a premium paid by the options buyer. They receive the option premium upfront but are obligated to sell the stock at the strike price if the option buyer exercises their right. The option seller's potential profit is limited to the premium received, while their potential losses are theoretically unlimited because the stock's price rise can rise indefinitely.
Closing Out a Naked Call
To close out a naked call position, the option seller can buy back the call option before its expiration date if the call is "out of money." Out of money (OTM) refers to a situation where the underlying asset's price is lower than the strike price of the call. This buyback may result in a profit if the option premium has decreased or a loss if the premium has increased because of a rise in the stock's price.
Possible Advantages of Using Naked Call
Some of the advantages of adopting naked call options as part of your investment strategy, include:
- Premium income: The option seller receives the premium upfront, which can be used to offset other investments or generate income.
- Profit from a stagnant or declining stock price: If the stock price remains below the strike price, the option will expire worthless, allowing the seller to keep the premium as profit.
- Limited capital requirement: Writing naked calls requires a margin account, but the initial capital requirement is lower than purchasing the underlying stock and you can walk away with the premium without investing your own money. Granted, if the price of the call option moves against you, additional margin may be required.
Things to Consider with Naked Calls
While naked calls can be profitable, here are a few considerations to keep in mind:
- Unlimited potential losses: The option seller may face substantial losses if the stock's price rises significantly.
- Margin requirements: Selling naked calls requires a margin account, and the margin requirement can change with fluctuations in the stock price.
- High-risk strategy: Naked calls are considered high risk because of the potential for unlimited losses and may not be suitable for all investors.
Example of a Naked Call
Say a stock is trading at $10, and you believe it will not exceed $20. You may sell a naked call option with a strike price of $20, betting on the stock not climbing higher than $20. Assume the premium you receive for the option per contract is $5, which will be your maximum gain on this transaction. The $5 profit will only be yours to keep if the buyer doesn't exercise the option.
If the stock price rises past the $20 mark contrary to your expectations and hits $40, and the option holder exercises the call option, you must buy 100 shares of that stock for $40. Each option contract equates to 100 shares. Since you have effectively sold shares at $20 previously, you will lose $20 per share, resulting in a net loss of $2,000 (100 x $20).
Naked Call Alternatives
Take a look at alternative strategies to naked call options to help you manage risks while profiting from various market conditions.
- Covered calls: Instead of selling naked calls, you can sell call options on a stock you own, limiting potential losses.
- Vertical spreads: By buying and selling call options with different strike prices on the same stock, you can create a vertical spread that limits your risk.
- Put options: Selling a put option can generate income and profit from a declining stock price while limiting potential losses.
Weighing the Risks and Rewards of Naked Calls
While naked calls offer the potential for premium income and the ability to profit from a stagnant or declining stock price, they also come with some risks. Investors must carefully weigh these risks and rewards before considering this high-risk strategy. It's essential to thoroughly understand options trading and the potential consequences before engaging in naked call writing.
Frequently Asked Questions
What's the difference between a naked call and a naked put?
A naked call involves selling a call option without owning the underlying stock, while a naked put involves selling a put option without holding a short position in the stock. In both cases, the option seller takes on significant risk, but a naked call has potentially unlimited losses, while a naked put has limited losses.
Is a naked call bullish or bearish?
A naked call is a bearish strategy, as the option seller hopes that the stock price will decrease or remain below the strike price, allowing them to keep the premium received from the option buyer.
How to use a naked call?
To use a naked call strategy, you sell a call option on a stock you do not own, hoping that the stock price will stay below the option’s strike price. This requires a margin account, an understanding of the risks involved and close monitoring of the stock’s price action so as to be ready to close out the position if necessary to cut losses.
About Anna Yen
Anna Yen, CFA is an investment writer with over two decades of professional finance and writing experience in roles within JPMorgan and UBS derivatives, asset management, crypto, and Family Money Map. She specializes in writing about investment topics ranging from traditional asset classes and derivatives to alternatives like cryptocurrency and real estate. Her work has been published on sites like Quicken and the crypto exchange Bybit.