What is a Naked Call
A naked call is an options strategy in which an investor writes (sells) call options on the open market without owning the underlying security. This stands in contrast to a covered call strategy, where the investor owns the underlying security on which the call options are written.
This strategy is sometimes referred to as an "uncovered call" or a "short call."
BREAKING DOWN Naked Call
A naked call strategy is inherently risky as there is limited upside profit potential and (theoretically) unlimited downside loss potential. The reason is that the maximum profit will be achieved if the underlying price falls to zero. The maximum loss 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 his/her risk tolerance and stop-loss settings.
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 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.
If the price of the stock rises 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.
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 (AMZN) was over when it finally leveled out in March 2017 near $852 per share. He/she 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.
The breakeven point for a naked call option is the strike price plus the premium. That gives the options seller a little leeway.
Want to know more? Read Naked Call Writing: A Risky Options Strategy