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 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:
Leverage for High Returns
A naked call enables an investor to profit from a possible increase in the underlying stock's price without having to own it. If the stock price increases substantially, the investor can gain from the difference between the strike price and the market price, resulting in substantial returns on investment.
Income Generation
Selling naked calls allows investors to earn immediate income by collecting premiums from the options sold. This strategy can create a steady cash flow, which may be particularly useful in a stagnant market.
Flexibility in Strategy
Naked calls can be included in a wider options trading strategy. Investors may use them alongside other options or stock positions to manage risks or improve returns, providing more flexibility in market navigation.
Capital Efficiency
Selling naked calls lets investors use their capital more effectively since they don't have to buy the underlying shares to take the position. This enables them to allocate that capital to other investments or strategies.
Market Sentiment Exploitation
Investors can benefit from their market expectations by utilizing naked calls. If they think the stock is overpriced and may drop, they can sell naked calls to gain from either the decrease in stock price or the time decay of the options if the stock stays stable.
Things to Consider with Naked Calls
While naked calls can be profitable, here are a few considerations to keep in mind:
Risk of Unlimited Losses
Naked calls expose the seller to potentially unlimited losses if the underlying asset's price rises significantly. Since the call option gives the buyer the right to purchase the asset at a predetermined price, if the asset's price rises significantly above the strike price, the seller must buy the asset at the higher market price to fulfill the obligation, leading to substantial losses.
Margin Requirements
Writing naked calls usually requires a substantial margin in the trading account to cover potential losses and ensure that the seller can meet their obligations. It’s essential to understand the margin requirements set by the brokerage and ensure that sufficient funds are maintained in the account.
Market Volatility
Consider the volatility of the underlying asset before initiating a naked call position. High volatility can lead to rapid price increases, increasing the likelihood of substantial losses for the seller. Monitoring market trends and volatility can help in making informed decisions.
Time Decay (Theta)
Naked calls rely on time decay, which can work in favor of the seller as the expiration date approaches. The value of options decreases over time, and sellers can profit if the underlying asset remains below the strike price. However, it's essential to balance this with the risk of unexpected price movements.
Understanding of Market Sentiment
Being aware of market sentiment and news that could impact the underlying asset is crucial when selling naked calls. Positive news or favorable market conditions can lead to sudden price spikes, exposing the seller to greater risk. Therefore, maintaining awareness of market developments is critical for decision-making.
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 is an options strategy in which the trader sells call options without owning the underlying asset, leading to potentially unlimited risk if the asset’s price increases significantly. Conversely, a naked put involves selling put options without a short position in the underlying asset, putting the trader at risk of having to purchase the asset at the strike price if its value drops below that level.
Is a naked call bullish or bearish?
A naked call is viewed as a bullish strategy since the seller benefits when the stock price rises above the strike price, enabling them to buy the shares at a lower price. Nonetheless, it carries risks and can be bearish if the stock price declines, as the seller faces unlimited loss potential.
How to use a naked call?
A naked call involves selling call options without having the underlying asset, which enables the trader to receive premium income if the option expires worthless. However, this strategy comes with considerable risk, as losses can be unlimited if the asset’s price increases significantly above the strike price.