In options terminology, "naked" refers to strategies in which the underlying stock is not owned and options are written against this phantom stock position.
The naked strategy is a more aggressive, having a lot more risk, but it can be used to generate income as part of a diversified portfolio. If not used properly, however, a naked call position can have disastrous consequences since a stock can theoretically rise to infinity. All of this and more is our focus in this article.
Uncommon Insights and Common Sense
Naked call writing is the technique of selling a call option without owning any stock. Being long a call means that you have bought the right to buy shares at a fixed price. On the other side of the transaction, the person who sold the call is said to be "short" the call, and his or her position can either be secured by shares (the covered call scenario) or unsecured (naked calls). This might be confusing, so here's a diagram that summarizes it for you:
Thus, naked calls are one means of being short a call. This is typically a more advanced level of options trading since there are more risks involved with such a position. This is why your broker might not permit you to start selling naked calls until you have met more stringent criteria (i.e., large margin account, many years of options experience, etc).
Something that often confuses investors is whether or not being short a call and long a put are the same. Intuitively, this might make some sense, since calls and puts are almost opposite contracts, but being short a call and long a put are not the same. When you are long a put, you have to pay the premium and the worst case will result in a loss of only the premium. However, when you are short a call, you collect the option premium, but you are exposed to a large amount of risk, which we discuss below.
When selling a naked call, you would instruct your broker to "sell to open" a call position. Remember that since you do not have a position in the stock, you will be forced to buy shares at the market price and sell them at the strike price if your calls turn out to be in-the-money. Now, let us consider the risks and payoffs in more detail.
The Risks and Rewards
A naked call position is much more risky than writing a simple covered call because you have essentially sold the right to something that you do not own. The closest parallel to such a transaction in the equity world is shorting a stock, in which case you do not own the stock you are selling. In the case of writing naked calls, you have sold someone the right to buy shares at a fixed price; you aim to make a profit by collecting the premium.
Let us consider the following example: ABC's stock trades for $100 and the $105 call that is one month to expiry trades at $2. You, not owning any ABC stock, can sell (write) a naked call at $2 and collect $200. By doing so, you are speculating that ABC stock will be below $107 ($105 + $2 premium) at expiry (if it is below $107, you will make a profit). Consider the payoff diagram:
As you can see, the losses mount as the price of the stock goes above the breakeven price of $107. Note also that at any price below $105, the profit for the seller of the option stays only at $200, which is the premium that was received. The naked call writer, therefore, is faced with the unattractive prospect of a limited profit and a seemingly limitless loss. Now you can see why your broker restricts this type of options trade!
Unwinding the Position and Other Considerations
To close out the position, you would need to consider whether the ABC option is in or out of the money. If the call is out of the money, you could buy back the call option at a cheaper price. If the call is in the money, you could either buy back the call option (at a higher price) or buy shares to offset the call. In either case, your downside would be protected.
It is important to note that since a naked call position has a lot of risk, investors typically offset part of the risk by purchasing another call or some stock.
The Bottom Line
Writing a naked call is an options strategy that has significant risks since the stock might move upwards. By its nature, writing a naked call is a bearish strategy that aims for a profit by collecting only the option premium. Due to the risks involved, most investors hedge their bets by protecting some of their downside with stock or other call options (at higher strike prices).