Basics of Naked Call Writing

02/20/2012 10:21 am EST

Focus: OPTIONS

Dan Passarelli

Founder, Market Taker Mentoring, LLC

Uncovered, or “naked” calls allow traders to collect sizable premiums when an option expires worthless, but due to unlimited risk and limited gain, this strategy is one of the riskiest ones around.

The “naked call” is defined as an option strategy where an option player sells (writes) call options without owning the underlying security. Some may refer to this strategy as an “uncovered call” or “short call.”

The goal of the naked call is for the trader to collect premiums if the option expires worthless. A trader could sell an out-of-the-money (OTM) naked call each month and pocket premiums, provided the stock price either stays flat or drops. This process could continue as long as the stock remains below the strike.

The Specifics
The maximum gain for selling a naked call is limited to the premium received for the call option. That said, the loss potential is unlimited because the stock can rise indefinitely.

If the underlying stock’s price is above the strike price at expiration, it will result in the trader having to sell the stock at the strike price (which will be lower than the market price).

A loss can occur if the stock price rises. If the price of the underlying stock is greater than the short call’s strike price plus the premium received at expiration, the option should be bought in to close the trade. Otherwise, when the option is assigned and a short-stock position is acquired, further losses are possible.

On the flip side, the maximum profit is achieved when the underlying stock is less than or equal to the strike price of the sold call at its expiration.

An Example
For this specific example, we will take a look at Apple (AAPL), which is trading around $500 at the time of this writing. A March 550 call carries a bid price of around $4.00. If the stock remains below the strike price by expiration, the call expires worthless and the call seller keeps the $4.00 in premium (less any commissions).

The problem is if the stock rallies through the strike price at expiration, the call will be assigned, resulting in a short sale of 100 shares at $550. With the stock at $570, that would represent a loss of $20 a share, or $2,000. Subtract the $400 received in premium and the total loss comes to $1,600.

Of course, it’s always helpful to look at the daily chart of the underlying stock when trading the options:

chart
Click to Enlarge

With unlimited loss potential, the naked call is considered one of the riskiest option strategies. A (perhaps) safer way to structure a trade with a similar risk profile is to sell a call credit spread.

See related: Understanding Debit and Credit Spreads

By Dan Passarelli of MarketTaker.com

Dan is also a frequent speaker at The Traders Expo.

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