What Is a Naked Call?

There are plenty of ways to profit on a stock's movement, beyond investing in the actual stock itself. Options provide a nearly endless array of strategies, due to the countless ways you can combine buying and selling call option(s) and put option(s) at different strike prices and expirations.

A call is an options contract that gives the owner the right to purchase the underlying security at the specified strike price at any point up until expiration. A put is an options contract that gives the owner the right to sell the underlying asset at the specified strike price at any point up until expiration.

When it comes to speculative options trading strategies, it doesn't get riskier than naked calls.

Selling something you don't have

A naked call is when a speculator or investor writes a call option without having a position in the underlying stock itself. To set up a naked call, an investor simply sells a call option without owning the underlying stock. The short side of a call option is required to deliver shares of the underlying stock if the option is exercised.

If you already have the stock, then it's generally not a problem to deliver it if the option is exercised, which is referred to as a covered call. Covered calls are one of the most conservative and low-risk options strategies out there.

However, if you don't already own the stock and you must deliver it, then you must go out and purchase the stock at prevailing market prices. But since stock prices theoretically have no maximum, the potential risks are enormous.

For example, if a stock is trading at $50, and an investor does not believe that the stock will rise above $60, then the investor may sell a naked $60 call. Let's say that the premium received for the call is $4.

Maximum loss: unlimited

Theoretically, there is no upper-bound limit to a stock's share price. If a naked call seller must purchase the underlying stock and then deliver it at the strike price, there is no limit to the potential losses. Of course, in reality stock prices don't increase to infinity, so this risk is purely hypothetical. However, there is still no specified limit on how much you could potentially lose on the trade.

In this example, if you had to deliver shares to sell at $60, but were forced to purchase at some unknown higher price, your effective losses would be the difference between what you had to purchase the stock at, and the strike price of $60. What if the underlying stock is acquired in a megamerger for $100? What about $200? At $200, we're talking about losing $140 per share on 100 shares, or a $14,000 loss for a single options contract, which wouldn't be offset by the $400 premium received.

However unlikely these scenarios might be in reality, they're still theoretically possible.

Maximum gain: net credit

For a naked call position, the investor sells a call option and receives a premium upfront. The goal of the trade is for the option to expire worthless, in which case the investor keeps the entire premium.

In this example, the $4 premium is the max gain.

Breakeven: strike price plus premium

The breakeven on a naked call is simply the strike price plus the premium. If the stock closes upon expiration at that price, then the losses associated with the trade will exactly offset the upfront premium received.

In this example, if the stock closed at $64, then the $4 in premium received upfront would cover the $4 in losses (buying at $64 and selling at $60).

Margin requirements

Considering the theoretically unlimited risk that you and your broker/dealer are exposed to, the margin requirements for naked calls are extremely high in order to maintain the position. Broker/dealers are able to implement margin requirements that are stricter than regulations, which will vary between broker/dealers. Check with your broker/dealer for specific requirements.

From a regulatory standpoint, Reg T requires:

  • Naked in-the-money call: 100% of the option market value plus 20% of the underlying equity price.
  • Naked out-of-the-money call: The greater of a) 100% of the option market value plus 10% of the underlying equity price, or b) 100% of the option market value plus 20% of the underlying equity price minus 100% of the out-of-the-money amount.

A potentially better way

Naked calls often prove to be more trouble than they're worth, in terms of risk exposure and margin requirement calculations. An alternative would be to create a wide bear call spread. You could choose to structure the spread wide enough that the premium received (net credit) would be comparable, while limiting risk and margin requirements by buying a long out-of-the-money call at a higher strike price.

The article What Is a Naked Call? originally appeared on Fool.com.

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