What are Naked Calls?
A naked call, also called an uncovered call option, is an extremely risky form of options trading when done wrong, overleveraged and without a stop loss (contingent) where the options trader sells a call option against an underlying asset without owning that asset.
This is a highly speculative form of options trading with profit potential that is limited and an unlimited loss potential. The trader stands to win big if the price of the underlying asset drops below the strike price on expiration, but will suffer ‘unlimited’ loss as the stock continues to go upwards. The naked call is therefore a bearish options trading strategy.
There are two strategies to the naked call option.
1) When price is neutral to moderately bearish
2) When price is expected to be extremely bearish
1) Neutral to Moderately Bearish
The trader’s goal is to collect premiums on a naked call option if the price of the underlying asset is flat on expiration, or has experienced a moderate drop.
Let us take an example using our stock XY, which is presently trading at $48 in April 2012. The trader places a naked call contract at $3 per share with a $50 strike price as follows:
– Sell 1 XY 50 Put to open @ $3 per contract ($300)
The trader will collect a premium of $300, pending the expiration of the trade.
The breakeven point from a naked call in our trade example is at $50.
Profit for a naked put option is limited to the premium on the trade. Since the trader does not have a long position on the underlying asset, he will not incur any loss if the option expires worthless at a price below strike price. So if from our example above, the stock price drops to $28, the option expires worthless and he keeps the premium.
So if the stock stays below $50 the trader gets to keep all of the premium he sold short.
A loss on a naked call occurs when the price of the underlying asset on expiration is greater than the strike price. If the price of XY from our example rises to $68, then the trader will have to buy the option at $6800 and sell it to the original option seller at the old strike price of $50 per share ($5000), incurring a loss of $1,800.
Naked calls are a risky way to trade options and should only be used by traders who know what they are doing.
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