Naked call

A naked call is a high-risk options strategy wherein the investor sells (writes) a call option without possessing the underlying stock. It is also referred to as an uncovered call as it doesn’t have the backing of an actual security. Investors engage in naked calls sans real share ownership to collect the initial call premium.

Investors undertake this risky proposition in the belief that the underlying asset price will surely decline. However, they may incur huge losses if the asset's value rises above the strike price. So, selling naked options is only fit for skillful speculators or investors with a powerful instinct regarding an asset’s price movements. Beginners should refrain from exposing themselves to such unlimited risks.

• A naked call is a high-risk options trading method allowing the investors to sell a call option without possessing the actual ownership of the underlying security.
• The naked call seller benefits from the underlying stock’s price fall on or before the call options expiration date.
• The naked call option has a limited profit possibility equal to the total premium amount received and, theoretically, unlimited potential for loss.
• The naked call has a breakeven point referring to the security’s value equivalent to the sum of its strike price and premium amount.

A naked call, also referred to as uncovered or short call, happens when the writer of a call option takes a short position without the protection of actual securities. Under a call option, the buyer has the right, but not obligation, to buy the underlying stock at the strike price on or before the expiry date. Since the writer does not possess any open position or physical asset in the futures market, it comes with unlimited risk.

This is because if the buyer of the call option exercises his right to buy the stock on or before the expiry of the contract, the writer must deliver the stocks. To honor the contract, the writer must purchase the stocks from the open market irrespective of how high the current market value is and offer them at the strike price.

Since there is no limit to which the stock prices could rise, the writer exposes himself to unlimited risk. At the same time, the maximum possible gain on a naked call is the premium obtained from the call option.

The objective of the naked call is to ensure that the option expires without the call being exercised, providing a full premium to the investor. Investors expect the price reduction of securities traded under naked call options. It helps them close their position economically. 

Moreover, the naked call is contrary to “Covered call,” a low-risk options strategy wherein the investors own the underlying security. To safeguard their interest, the naked call writers must either buy similar options to balance the transaction or occupy a position in the futures market to invalidate the damage. 

Although the stock prices do not achieve an unfathomed level, theoretically, the prospective trading loss limit remains indefinite. With the possibility of a loss looming large, brokerage firms permit using such strategy subject to meeting specific requirements.

To retain the position, the margin requirements for selling naked call options are quite high. The brokers may set more rigid requirements as per their preferences. It entails the greater of the two:

• 10% of the underlying security value + Received upfront premium, or
• 20% of the underlying security value + Received upfront premium – Out-of-the-money amount (if any)

This advanced options strategy comes with a bearish market view. It assists the investors in maximizing the movement of a stock price. Thence, investors must handle this complex trading approach with proper caution and complete market know-how. 

Suppose that stock ABC is currently trading at $10. Harry believes that it will not exceed $15. Therefore, without owning ABC stock, he sells a naked call option to sell ABC stock for a premium of $5 to a buyer named Gina at a strike price of $20 and expiration month of March. Gina is expecting the price to rise to over $15.

Note that an options contract is to buy 100 shares. So, the premium received by Harry for 100 shares is $500 (5*100).

Now, there are three possibilities:

#1 - The ABC stock reduces to $9 on or before the expiration

It implies that call option expires worthless. This is because Gina, most likely, will not exercise her right to buy the stock as there is no possibility to sell it further to make a profit.

So, Harry keeps the complete premium of $500 as profit, whereas Gina loses $500 she paid as premium to Harry. 

#2 - The ABC stock remains at $10 on or before the expiration

It also signifies a worthless expiration. This signals a $500 profit for Harry and a 100% loss for Gina. 

#3 - The ABC stock surges to $25 on or before the expiration

In this scenario, Gina will exercise her right to buy the ABC stocks as per the call option. This is because she could profit by reselling the ABC stock in the open market at a higher market price.

Now, Harry does not own 100 shares of ABC, but he has to deliver them to Gina. This means he has to buy the shares at the current market price of $25 from the market and give them to Gina at the strike price of $15. His loss will be reduced by the premium he received earlier.

Current market price of 100 shares – $2500 ($25*100)

Strike price – $1500 ($15*100)

Call premium – $500

Loss to Harry = Current market price – Strike price – Call premium = $2500 - $1500 - $500 = $500

Therefore, Harry will have to bear the loss of $500, i.e., $5 per share.

Gina’s profit will be equal to Harry’s loss. She will have to pay Harry at the rate of $15 per share. However, she can sell the stocks in the market at $25 to make up for the premium of $5 per share she paid to Harry.

Profit to Gina = Current market price – Strike price – Call premium = $2500 - $1500 - $500 = $500

Hence, in this case, Harry stands to lose $500, while Gina gains the same amount.

A naked call option strategy means that investors with no ownership of the underlying stocks can still short-sell them. As mentioned before, it is a problematic options trading approach deemed fit only for professional investors. This approach involves selling any one type of call option, i.e., ITM (In-the-money) or OTM (Out-of-the-money). 

If stocks’ rates remain below the strike price by the expiration date, the options seller gets the full premium as profit. However, if the rates surpass the strike price amount by the expiration date, the seller may purchase shares for the buyer at the market rate and bear the loss. Moreover, those same shares are available to the buyer at the options strike price, who can sell them at market rate to make profit.

The naked call strategy breaks even when the security’s value is the total strike price and the premium amount. This is because stock expiration at that specific rate supports counterbalancing any losses with the earned premium amount. 

Therefore, this strategy must be used only when the investor is sure the stock rates would fall in the near future. Otherwise, the investor may face substantial losses.

This has been a guide to Naked call & its Definition. Here we explain the naked call strategy and how to use it, along with examples and calculations. You can learn more from the following articles – 

• Writing Call Options
• Call Options vs Put Options
• Put-Call Ratio