A naked call, or uncovered call, is an aggressive, high-risk option strategy. It occurs when an investor sells or writes call options for which they don’t own the underlying security. The seller is betting that the underlying stock price will not increase before the call’s expiration date.
It is safer for traders to sell calls on a stock they already own. This way, if the stock price increases sharply, the trader’s net position is hedged. A hedged position, in this example, means that as the stock value rises, the long-stock position grows while the short-call option position loses. This situation describes a “covered call” position, which is a much lower risk strategy.
Naked calls, on the other hand, are speculative trades. You keep the premium if the underlying asset is at or in the money at expiration, but you also have the potential for unlimited losses. Read on for more about what naked calls are, how they work, their risks and rewards, and more.
Understanding Naked Calls
When a trader sells or writes a call option, they are selling someone else the right to purchase shares in the underlying asset at the strike price. In exchange, they receive the option premium. While this immediately creates income for the option seller, it also opens them up to the risk that they will need to deliver shares in the underlying stock, should the option buyer decide to exercise.
For this reason, it is significantly less risky to use a “covered call strategy” or sell an option on an underlying asset that you own. In the case of stocks, a single option generally represents 100 shares, so the trader would want to own 100 shares for each option sold.
Trading naked calls, on the other hand, is among the more speculative options strategies. The term “naked” refers to a trade in which the option writer does not own the underlying asset. This is a neutral to bearish strategy in that the seller is betting the underlying stock price will not materially increase before the call option’s expiration date.
In both the naked and the covered scenarios, the option seller gets to collect the premium as income. However, selling a naked call requires a much lower capital commitment, since the seller is not also buying or owning the corresponding number of shares in the underlying stock. While this increases the potential return profile of the strategy, it opens the seller up to potentially unlimited losses on the downside.
How Do Naked Calls Work?
The maximum profit potential on a naked is equal to the premium for the option, but potential losses are limitless. In a scenario where the stock price has gone well above the strike price, and the buyer of the option chooses to exercise, the seller would need to purchase shares at the market price and sell them at the strike price. Hypothetically, a stock price has no upper limit, so these losses could become great. When writing a naked call, the “breakeven price” is the strike price plus the premium collected; a profit is made when the stock price is below the breakeven price.
Investing in naked calls requires discipline and a firm grasp on common options trading strategies.
Writing a Naked Call
While there are significant risks, the process of naked call writing is relatively easy. An individual enters an order to trade a call option, but instead of buying they enter a sell-to-open order. Once sold, the trader hopes the underlying stock moves sideways or declines in value.
So long as the shares do not rise quickly, and ultimately remain below the strike price at expiration, the naked call writer will keep the premium collected (also known as the credit). Unexpected good news or simply positive price momentum can send the stock price upward, leading to higher call option values.
On the most common stocks and exchange-traded funds (ETFs), there are dozens of option strike prices at various expiration dates. For this reason, a trader must make both a directional bet on the underlying stock price and a time-wager based on the expiration date. Keeping a close eye on implied volatility is important, too.
Closing Out a Naked Call
When the trader wants to exit the trade, they punch in a buy-to-close order on the short calls. Alternatively, a trader can buy shares of the underlying asset to offset the short call position.
Naked Call Example
Let’s say a trader wants to sell a naked call option on shares of XYZ. Let’s also assume the stock trades at $100 per share.
For our example, we will assume the trader sells a call option at the $110 strike price expiring three months from today. This option might have a premium, or cost, of $5. The call option is said to be “out of the money” since the strike price is above the underlying stock’s current price.
Thus, the option only has extrinsic value (also known as time value). This naked call example seeks to benefit from the option’s time decay, also known as its theta. At initiation, the trader sells to open, then collects the $5 premium per share.
The trade’s breakeven price is $115 ($110 strike price plus $5 premium). Jump ahead a month, and shares of XYZ have rallied to $110. The value of the $110 strike call option, now expiring in just 60 days, is worth $9 since the share price rose $10.
On the other hand, the option’s time value dropped modestly since the expiration date drew closer. After pocketing the $5 premium at the trade’s initiation, the trader effectively owes $9 back, resulting in a net loss on paper.
Fast-forward to the week of expiration: XYZ’s stock price has fallen to $100. The $110 call option with just a few days left until expiration – Friday, is worth just $0.50 of time value with no intrinsic value. The trader chooses to close the trade with a buy-to-close order to lock in that $0.50 price.
In summary, the trader collected the $5 premium at the onset of the trade, experienced paper losses when XYZ’s stock price rose, but then ended on the winning side of the ledger by expiration when the position closed. The traders realized a profit of $4.50 considering the $5 sell and $0.50 buy-back. The trader could have also allowed the option to potentially expire worthless, which could have netted a $5 profit.
Using Naked Calls
Trading naked calls sometimes appeals to new traders who do not fully grasp risk and return probabilities. The notion that you can make money simply if a stock price or ETF does not go up in value sounds great. The problem arises when the underlying security appreciates quickly.
A naked call writer might not have enough cash to close the position. For this reason, brokers often have margin requirements on traders seeking to sell naked calls. When an account’s margin depletes too far, the broker can issue a margin call requiring the trader to deposit more cash or assets.
In general, naked calls make the most sense for experienced traders who have a risk management strategy in place before engaging in this type of trade.
Risks and Rewards
The potential for unlimited losses makes naked call writing a risky strategy. The reward is straightforward — keeping the premium received at the onset of the trade. Here are the pros and cons of naked call option trading:
|Potential profits from a flat or declining stock price||Unlimited loss potential|
|Allows theta to work in your favor||Reward limited to the premium collected|
|Generates income||Margin calls when the underlying appreciates|
Naked Call Alternatives
A common alternative to selling a naked call is to simply own the stock then sell calls against that position. This technique is known as “covered call writing”. This is a safer alternative to risky naked calls, but the trader must have enough cash to purchase the necessary shares.
One options contract covers 100 shares, so purchasing 100 shares of XYZ at $100 per share requires $10,000 of capital, unless the investor makes use of margin trading.
Other complex options strategies can achieve results similar to naked call writing. Covered puts, covered calls, and bear call spreads are common alternatives to naked calls. Experienced options traders have strategies to manage their risk, but even sophisticated traders can become overconfident and make mistakes.
Selling naked puts is another alternative that takes a neutral to bullish outlook on the underlying. When selling naked puts, the trader’s loss potential is limited to the strike price (minus the premium collected) since the stock can only go to $0.
A naked call strategy is a high-risk technique in which a trader seeks to profit from a declining or flat stock price. The maximum gain is the premium received while the risk is unlimited potential losses. As with all option trading strategies, traders need to understand the risks and benefits of selling naked calls.
However, you can also build a well-rounded portfolio without using options. A great way to get started may be by opening an account on the SoFi Invest® online brokerage. While SoFi does not currently offer options, it does allow you to buy and sell stocks, exchange-traded funds, and trade cryptocurrency.
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