What Is a Naked Call?
This strategy, sometimes referred to as an uncovered call or an unhedged short call, stands in contrast to a covered call strategy, where the investor owns the underlying security on which the call options are written. A naked call can be compared with a naked put.
- A naked call is when a call option is sold by itself (uncovered) without any offsetting positions.
- When call options are sold, the seller benefits as the underlying security goes down in price.
- A naked call has limited upside profit potential and, in theory, unlimited loss potential.
- A naked call's breakeven point for the writer is its strike price plus the premium received.
Understanding Naked Calls
A naked call gives an investor the ability to generate premium income without directly selling the underlying security. Essentially, the premium received is the sole motive for writing an uncovered call option.
It is inherently risky as there is limited upside profit potential and, in theory, unlimited downside loss potential. In fact, the maximum gain is the premium that the option writer receives upfront, which is usually credited to their account. So, the goal for the writer is to have the option expire worthless.
The maximum loss, however, is theoretically unlimited because there is no cap on how high the price of the underlying security can rise. However, in more practical terms, the seller of the options will likely buy them back well before the price of the underlying rises too far above the strike price, based on their risk tolerance and stop-loss settings.
Margin requirements, understandably, tend to be quite steep given the unlimited risk potential of this strategy.
A seller of call options, therefore, wants the underlying security to fall, so that they can collect the full premium if the option expires worthless. But, if the price of the underlying security instead rises, they may end up having to sell the stock at a price far below the market price because the option buyer may decide to exercise their right to purchase the security—that is, they would be assigned to sell the stock.
The breakeven point for the writer is calculated by adding the option premium received to the strike price of the call that has been sold.
A rise in implied volatility is not desirable to the writer as the probability of the option being in the money (ITM), and thus being exercised, also increases. Since the option writer wants the naked call to expire out of the money (OTM), the passage of time, or time decay, will have a positive impact on this strategy.
As a result of the risk involved, only experienced investors who strongly believe that the price of the underlying security will fall or remain flat should undertake this advanced strategy. The margin requirements are often very high for this strategy due to the propensity for open-ended losses, and the investor may be forced to purchase shares on the open market prior to expiration if margin thresholds are breached.
The upside to the strategy is that the investor could receive income in the form of premiums without putting up a lot of initial capital.
Using Naked Calls
Again, there is a significant risk of loss with writing uncovered calls. However, investors who strongly believe the price for the underlying security, usually a stock, will fall or stay the same can write call options to earn the premium. If the stock stays below the strike price between the time the options are written and their expiration date, then the options writer keeps the entire premium minus commissions.
Should, on the other hand, the price of the stock rise above the strike price by the options expiration date, then the buyer of the options can demand the seller to deliver shares of the underlying stock. The options seller will then have to go into the open market and buy those shares at the market price to sell them to the options buyer at the options strike price.
If, for example, the strike price is $60 and the open market price for the stock is $65 at the time the options contract is exercised, the options seller will incur a loss of $5 per share of stock less the premium received.
The premium collected will somewhat offset the loss on the stock but the potential loss can still be very large. For example, let's say an investor thought that the strong bull run for Amazon.com was over when it finally leveled out in March 2017 near $852 per share.
The investor wrote a call option with a strike price of $865 and an expiration in May 2017. However, after a short pause, the stock resumed its rally and by the mid-May expiration, the stock reached $966.
The potential liability was the exercise price of $966 minus the strike price of $865, which resulted in $101 per share. This is offset by whatever premium was collected at the start.