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Naked call

Updated on January 4, 2024
Article byHimani Bhatt
Reviewed byDheeraj Vaidya, CFA, FRM

Naked Call Definition

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.

Naked call

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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 priceStrike PriceExercise price or strike price refers to the price at which the underlying stock is purchased or sold by the persons trading in the options of calls & puts available in the derivative trading. Thus, the exercise price is a term used in the derivative market.read more. So, selling naked options is only fit for skillful speculators Speculators A speculator is an individual or financial institution that places short-term bets on securities based on speculations. For example, rather than focusing on the long-term growth prospects of a particular company, they would take calculated risks on a stock with the potential of yielding a higher return.read moreor investors with a powerful instinct regarding an asset’s price movements. Beginners should refrain from exposing themselves to such unlimited risks.

Key Takeaways

  • 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.

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Naked Call Option Explained

A naked call, also referred to as uncovered or short call, happens when the writer of a call optionCall OptionA call option is a financial contract that permits but does not obligate a buyer to purchase an underlying asset at a predetermined (strike) price within a specific period (expiration).read more takes a short positionShort PositionA short position is a practice where the investors sell stocks that they don't own at the time of selling; the investors do so by borrowing the shares from some other investors to promise that the former will return the stocks to the latter on a later date.read more 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 marketFutures MarketA futures market is a financial marketplace where participants trade futures contracts for commodities, stock indices, currency pairs, and interest rates at a pre-determined rate and agreed-upon future date. It, thus, protects investors and traders from losing money on a transaction even if the price of the commodity or financial instrument rises or falls later.read more, 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.

Margin Requirements for Naked Calls

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 Bearish Bearish market refers to an opinion where the stock market is likely to go down or correct shortly. It is predicted in consideration of events that are happening or are bound to happen which would drag down the prices of the stocks in the market.read moremarket 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. 

Examples with Calculation

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 contractOptions ContractAn option contract provides the option holder the right to buy or sell the underlying asset on a specific date at a prespecified price. In contrast, the seller or writer of the option has no choice but obligated to deliver or buy the underlying asset if the option is exercised.read more 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 priceMarket PriceMarket price refers to the current price prevailing in the market at which goods, services, or assets are purchased or sold. The price point at which the supply of a commodity matches its demand in the market becomes its market price.read more.

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.

How to Use?

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 tradingOptions TradingOptions trading refers to a contract between the buyer and the seller, where the option holder bets on the future price of an underlying security or index.read more approach deemed fit only for professional investors. This approach involves selling any one type of call option, i.e., ITM (In-the-moneyIn-the-moneyThe term "in the money" refers to an option that, if exercised, will result in a profit. It varies depending on whether the option is a call or a put. A call option is "in the money" when the strike price of the underlying asset is less than the market price. A put option is "in the money" when the strike price of the underlying asset is more than the market price.read more) or OTM (Out-of-the-moneyOut-of-the-money”Out of the money” is the term used in options trading & can be described as an option contract that has no intrinsic value if exercised today. In simple terms, such options trade below the value of an underlying asset and therefore, only have time value.read more). 

Naked call Option

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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.

Frequently Ask Questions (FAQs)

Q#1 – Should I use a naked call?

A – You must use a naked call only when you can predict stock price movements accurately. For this, you must have thorough stock market knowledge. A naked call is a risky approach with the possibility of unlimited loss, thus deemed unfit for novice traders. Hence, only well-informed and experienced investors with a high-risk tolerance may give it a shot.

Q#2 – How to shield from the loss by naked calls?

A – You must either purchase similar options to cancel the effect of any associated losses or bag a position in the futures market to repeal any financial loss. This will assist you in trading with minimum prospective financial damage.

Q#3 – When to sell the naked call options?

A – You must sell naked call options when you are assured of the declining rates in current stocks. Ensure to keep tabs on the stock price fluctuations, current financial trends, and the individual company’s performance.

Q#4 – What if the stock rate rises above the options strike price?

A – If the stock price goes beyond the options strike price, the seller faces capital loss while the buyer earns considerable profits. The seller must buy the shares at the current market price and deliver them to the buyer at the options strike price.

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 – 

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