In options terminology, "naked" refers to strategies in which the underlying security is not owned and options are written against this phantom security position. The naked strategy is aggressive and higher risk but can be used to generate income as part of a diversified portfolio. However, if not used properly, a naked call position can have disastrous consequences since a security can theoretically rise to infinity.
How To Write Naked Calls
Naked call writing is the technique of selling a call option without owning the underlying security. Being long a call means you have the right to buy the security at a fixed price. On the other side of the transaction, the counterparty who sold the call is said to be "short" the call, and his or her position can either be secured by underlying ownership (covered call) or unsecured (naked call). This might be confusing so here's a diagram that summarizes these relationships:
Thus, naked calls are one means of being short a call. This is typically a more advanced level of options trading since there are greater risks. In fact, the broker may not permit the position until the account holder meets stringent criteria i.e. large margin account and/or years of experience.
When selling a naked call, you instruct the broker to "sell to open" a call position. Since you do not have an underlying position, you will be forced to buy the security at the market price and sell at the strike price if those calls go in-the-money.
Many investors aren't sure if being "short a call" and "long a put" are the same thing. Intuitively, this makes sense because calls and puts are almost opposite contracts but they aren't the same thing. When you are long a put, you have to pay the premium and the worst case scenario will result in premium loss and nothing else. However, when you are short a call, you collect the premium but are exposed to greater risk, which is discussed below.
Risks and Rewards
A naked call is much riskier than writing a covered call because you have sold the right to something that you do not own. The closest parallel in the equity world is shorting a stock, in which case you borrow the stock you are selling. When writing naked calls, you sell the right to buy the security at a fixed price; aiming to make a profit by collecting the premium.
Assume that ABC stock trades for $100 and the $105 call with one month to expiration trades at $2. You can sell (write) a naked call for $2 and collect $200 in option premium. In doing so, you are speculating that ABC stock will be below $107 ($105 + $2 premium) at expiration. i.e. you make a profit if is below $107.
Consider the payoff diagram:
As you can see, losses mount quickly as the price of the stock goes above the $107 breakeven price. Also note that, at any price below $105, the profit for the seller of the option remains at $200, which is the received premium. The naked call writer is faced with the unattractive prospect of a limited profit and a seemingly limitless loss. You can now see why brokers may restrict access to this options strategy.
It is important to note that, since a naked call position carries major risk, investors typically offset part of the risk by purchasing another call or some underlying security.
Closing Out Naked Calls
In the above example, you need to consider whether the ABC option is in or out of the money before closing the position.. If the call is out of the money, you can buy back the call option at a cheaper price. If the call is in the money, you can a) buy back the call option at a higher price or b) buy shares to offset the call.
In both cases, your downside is protected.
The Bottom Line
Writing a naked call is an options strategy that carries significant risks because the security can move higher. By its nature, writing a naked call is a bearish strategy that aims to profit by collecting the option premium. Due to the risks, most investors hedge their bets by protecting some downside with securities or other call options at higher strike prices.