11/21/2012 7:00 am EST
The recent precipitous slide of Apple’ stock price has some declaring that the company is the new Sony, while others contend it’s a better buy now. John Kmiecik of Market Taker Mentoring illustrates how a risky option strategy could backfire, if and when AAPL rises again.
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 maximum gain for selling a naked call is limited to the premium received for the call option. That said, the loss potential is unlimited—as 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.
For this specific example, we will take a look at Apple (AAPL)—which is trading right around $600 at the time of this writing. A December 650 call carries a bid price of 7.00. If the stock remains below the strike price by expiration, the call expires worthless and the call seller keeps the 7.00 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 $650. With the stock at $670, that would represent a loss of $20 a share, or $2,000. Subtract the $700 received in premium and the total loss comes to $1,300.
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.
By John Kmiecik, Senior Options Instructor, Market Taker Mentoring