In the dynamic world of options trading, the “naked call” is a term that’s both intriguing and somewhat intimidating. It evokes a sense of danger, a thrilling leap into the unknown, and indeed, it can be one of the riskiest strategies in trading. Yet, for the daring and well-informed, it can also present opportunities for significant gains.
What’s a Naked Call?
A naked call, also known as an uncovered call, is an options strategy where an investor sells call options without owning the underlying security. This contrasts with a covered call strategy, where the investor owns the underlying asset. Selling naked calls allows the investor to generate premium income, but it’s a high-risk strategy that could potentially lead to unlimited losses.
Think of it like this: imagine you’re selling tickets to a concert. In a covered call scenario, you own the tickets that you’re selling. In a naked call scenario, however, you’re selling tickets you don’t own, betting that you can buy them later at a lower price. Now, if the price of those tickets skyrockets, you’re in a bind, having to buy those tickets at a much higher price to deliver them to your buyer.
The Risks and Rewards
The main allure of selling naked calls is the potential to earn premium income. When you sell a call option, you receive the option premium upfront. If the price of the underlying asset falls or stays below the strike price, the option will expire worthless, and you keep the entire premium.
However, this strategy comes with a substantial amount of risk. If the price of the underlying asset rises above the strike price, the call option will be in-the-money. As the seller of the call option, you’d be obligated to deliver the asset at the strike price, even if that means purchasing the asset at the current (higher) market price.
This is where the risk of unlimited losses comes into play. There’s no cap on how high a stock’s price can rise. Consequently, there’s theoretically no limit to the loss you might sustain when selling naked calls.
A Practical Example
To better understand the concept of a naked call, let’s walk through a hypothetical scenario. Let’s say you decide to sell a naked call option for company XYZ at a strike price of $50, and you receive a premium of $2 per share.
- If the stock’s price remains below $50 until the option’s expiration date, the option expires worthless. You get to keep the $2 premium as your profit.
- If the stock’s price rises to $60, you’d need to buy the stock at $60 and sell it to the option buyer at $50, resulting in a loss of $8 per share ($10 price difference minus the $2 premium).
- If the stock’s price shoots up to $100, your loss jumps to $48 per share ($50 price difference minus the $2 premium).
The Anatomy of a Naked Call
Let’s break down the components of a naked call option:
- Seller/Writer: The person who initiates the contract is the seller, or writer, of the call option.
- Buyer: The person who purchases the call option.
- Premium: This is the price the buyer pays the seller to obtain the right granted by the option.
- Strike Price: This is the price at which the underlying asset may be bought or sold.
- Expiration Date: The option must be exercised before this date. After this date, the option is worthless.
The Landscape of Risks
Understanding the potential risks is critical when considering naked call options. Here are the top risks associated with this strategy:
- Market Volatility: Sudden price spikes can lead to substantial losses.
- Limited Profit Potential: The maximum gain is limited to the premium received.
- Unlimited Loss Potential: There’s no cap to potential losses if the stock price shoots up.
- Requirement of High Margin: Due to its high-risk nature, brokers usually require a significant amount of margin to sell naked call options.
The “Naked” in Other Trading Instruments
The concept of ‘naked’ isn’t exclusive to call options. There’s also the ‘naked put,’ another risky trading strategy where an investor sells put options without shorting the underlying security. Much like its counterpart, the naked put strategy allows the investor to earn premium income but exposes them to the potential risk of the stock’s price falling significantly.
A Deeper Dive into Our Example
To add more context to our previous example, let’s consider the market conditions. Assume you sold a naked call on XYZ when the stock was trading at $40. Your analysis suggested that the company’s new product would be a flop, and the stock price would decline.
Unfortunately, the product turned out to be a major hit, propelling the stock price upwards. As the price passes your strike price of $50, you start to incur losses. The stock continues to climb, hitting $60, then $70, and finally peaking at $100 on the day of expiration.
To meet your obligation, you must buy shares at the market price ($100) and sell them at the strike price ($50), resulting in a significant loss. After deducting the initial premium of $2, your total loss per share is $48.
This scenario illustrates why the naked call strategy is often compared to picking up pennies in front of a steamroller. The potential profits (the pennies) are dwarfed by the potential losses (the steamroller).
Making Naked Calls Safer
While selling naked calls can be risky, there are ways to mitigate that risk. One strategy is to sell out-of-the-money calls, which gives the stock more room to move before the option becomes in-the-money. Another is to use stop orders to limit potential losses.
Remember, though, even with these safety measures, selling naked calls remains a high-risk strategy. It’s essential to be fully aware of the risks involved and to use this strategy judiciously.
The Naked Call vs. The Covered Call
It might be helpful to compare the naked call to its less risky cousin, the covered call. In a covered call strategy, you own the underlying asset. This means that if the stock price rises above the strike price, you can deliver the stock without having to buy it at the higher market price.
This is why covered calls are a popular strategy for generating additional income on a stock portfolio. They offer the benefits of options trading – the ability to earn premium income – without the unlimited downside risk of naked calls.
Conclusion
The world of naked call options is not for the faint-hearted. It is a high-risk, high-reward strategy that requires careful consideration, thorough market analysis, and a clear understanding of the potential losses. If executed wisely and with caution, it can be a profitable strategy. But always remember, when it comes to naked calls, it’s best to be brave but not foolhardy.
As they say in the financial world, don’t walk around naked unless you can handle the exposure. So, before you decide to bare it all and sell naked calls, make sure you fully understand the risks involved and are ready to manage them effectively.
Frequently Asked Questions (FAQs)
What is a naked option? A naked option is a type of options strategy where the investor, or the writer of the option, does not own the underlying security when the option is sold. This strategy is considered risky as it exposes the investor to potentially significant losses if the market moves unfavorably.
What is a naked put? A naked put, also known as an uncovered put, is a put option where the option writer does not have the underlying security in their possession when the option is sold. It’s a high-risk strategy with the potential for substantial losses, but it can also bring in premium income if the stock price stays above the strike price.
What is naked option selling? Naked option selling refers to the act of selling options — either calls or puts — without owning the underlying asset. It’s called ‘naked’ because the seller is exposed to significant risk if the market price moves unfavorably. The seller’s potential loss from a naked call is unlimited, while the potential loss from a naked put is the strike price minus the premium received.
What is buying uncovered calls? Buying uncovered calls is not a common phrase in the world of finance. Typically, you would hear about selling or writing uncovered (or naked) calls. However, if someone refers to buying uncovered calls, they might be referring to purchasing call options where the seller (or writer) does not own the underlying asset.
What are uncovered call margin requirements? Uncovered call margin requirements refer to the amount of money a broker requires an investor to have in their account before they can sell uncovered or naked call options. Because selling naked calls is a high-risk strategy with potentially unlimited losses, brokers typically require a substantial margin. The exact margin requirement varies by broker and by the specifics of the contract.
Can you sell covered calls on Robinhood? Yes, you can sell covered calls on Robinhood, given you have been approved for Level 3 options trading by Robinhood. To sell a covered call, you need to own at least 100 shares of the underlying stock. Remember that options trading has significant risks and isn’t suitable for every investor.
What is an uncovered call option example? Let’s assume that you believe that Company XYZ’s stock, currently trading at $40, won’t go above $50 within the next month. So, you decide to write (sell) a naked call option with a strike price of $50, and for that, you receive a premium of $2 per share. However, if the stock price skyrockets to $70 due to unforeseen circumstances, you’ll be required to buy the stock at the current price ($70) and sell it to the option buyer at the strike price ($50). Your loss, in this case, would be $20 per share (minus the $2 premium), leading to substantial losses. This example illustrates the risk involved in selling uncovered or naked call options.