Naked Call Strategy: Definition & How It Works

Views 1334 Jul 24, 2024

Option writers sometimes deploy a strategy where they don't hold the underlying asset, known as the naked call strategy (or uncovered call). The naked call approach is recognized for its high risk and is generally only employed by seasoned traders who possess a bearish perspective on the underlying asset. Some experienced, risk-tolerant traders take this approach when they speculate that the asset's price will either remain unchanged or decline.

Read on to learn more about this options strategy.

What is a naked call

A naked call strategy is used when the seller (writer) of the call option does not own the underlying asset. Instead, they are selling call options to buyers who are willing to pay a premium for the right, but not the obligation, to buy the underlying asset at a specified price (strike price) within a certain period (expiration date).

If the buyer of the call option decides to exercise their right to buy the underlying asset, as the writer, you are obligated to sell it at the strike price, regardless of the underlying asset's current market price. The profit potential is limited to the premium received when you sell the call option.

The potential losses associated with the sale of a naked call are unlimited because the price of the underlying asset can theoretically rise infinitely. If the market price of the underlying asset rises significantly above the strike price, the losses from assignment can exceed the premium received, resulting in substantial net losses.

The margin requirements for this strategy are typically quite high due to the potential for unlimited losses. Should the margin threshold be exceeded, the investor might be compelled to buy shares in the open market before the option's expiration.

How do naked calls work

As an options writer, you can choose an underlying asset on which you want to sell call options. This could be a stock, an index, or another financial instrument. Then you'll determine the exercise date and the strike price that you're willing to sell the underlying asset if exercised.

When you sell naked calls, you receive a premium from the buyers, which is the price they pay for the right to potentially buy the underlying asset from you at the strike price.

Note that by selling naked calls, you take on the obligation to sell the underlying asset to the option buyer at the strike price if they choose to exercise the option. This obligation exists until the expiration date of the option contract or if you close out the contract early by buying to close the position.

Example of a naked call

Here is an example of a naked call option strategy.

Let's say you believe the stock price of a company is going to decrease in the near future and you want to execute a naked call option strategy. The stock is trading at $50 per share. You sell one naked call option contract with a $55 strike price and an expiration date one month from now. The premium you receive (for selling the option) is $3 per share.

Possible expiration scenarios can include:

If the stock price is below $55 at expiration: You keep the premium of $3 per share, as the option expires worthless.

If the stock price rises above $55 by expiration: The buyer of the call option can exercise their right to buy shares from you at $55 per share, even though the market price is higher. You'd be obligated to purchase the underlying asset at the current market price to fulfill the contract and sell it at the strike price.

Maximum Loss/Profit

Theoretical maximum loss: Theoretically unlimited. In a worst-case scenario, if the stock price were to rise indefinitely, the investor would be obligated to purchase the stock at the market price, regardless of how high it might be, and sell it at the strike price.
Theoretical maximum profit: Limited. A favorable outcome can occur if, by expiration, the stock price remains below the strike price. In this scenario, the option expires worthless, allowing the investor to keep the premium received from selling the call option.

Naked calls vs covered calls: What are the differences

Naked calls and covered calls are two unique trading strategies with different risk profiles and profit potential. Here are some key differences between them.

Ownership of the underlying asset

Naked calls: The seller (writer) of the call option does not own the underlying asset.
Covered calls: The seller of the call option owns the underlying asset, selling call options against the assets they already hold in their portfolio.

Market sentiment

Naked calls: Used when somewhat bearish to neutral on the underlying stock.
Covered calls: Employed when neutral to slightly bullish. The investor's sentiment may influence the strike price chosen.

Obligation and risk

Naked calls: Involves significant risk, as the seller has an obligation to sell the underlying asset at the strike price if the option is exercised. Since the seller does not own the asset, they are exposed to potentially unlimited losses if the asset's price rises sharply.
Covered calls: Involves less risk compared to naked calls because the seller already owns the underlying asset. If the option is exercised, they can fulfill their obligation by selling the asset they already own at the agreed-upon strike price. A risk to consider when selling a covered call is the potential of selling the asset if its price rises above the strike price and missing out on potential additional profit. Another consideration is the premium earned from selling the call only provides a small cushion on the downside in case the underlying stock price falls significantly.

Profit and Loss potential

Naked calls: Limited to the premium received from selling the call option. If the option expires worthless, the seller keeps the premium as profit. However, if the asset's price rises significantly, potential losses can be unlimited.
Covered calls: Limited to the premium received from selling the call option, plus any potential gains from the increase in value of the owned shares of the underlying asset. If the option is exercised, the seller can profit from selling the asset at the strike price assuming they purchased the stock at the same time as the call option and the call option's strike price is above the purchase price of the stock. Their potential upside is capped at the strike price plus the premium received.

Market outlook

Naked calls: Typically used by experienced, risk-tolerant options traders who have a bearish outlook on the underlying asset and expect its price to either remain stagnant or decline.
Covered calls: Often used by investors who have a neutral or slightly bullish outlook on the underlying asset. They are willing to sell the asset at a predetermined price (strike price) in exchange for earning premium income from selling call options.

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