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Naked call

What Is a Naked Call?

A naked call is an advanced options trading strategy where an investor sells a call option without owning the underlying security. This position is also known as an "uncovered call." As a strategy within the broader category of derivatives, selling a naked call is speculative and carries theoretically unlimited risk, making it one of the riskiest options strategies. The seller of a naked call receives a cash payment, known as the premium, upfront. This premium represents the maximum profit potential for the seller, regardless of how high the price of the underlying asset may rise.

History and Origin

The concept of options, in various forms, has existed for centuries, with early examples tracing back to ancient Greece. However, the modern, standardized options market began with the establishment of the Chicago Board Options Exchange (CBOE) in 1973. This development allowed for exchange-listed options contracts with standardized terms, centralizing liquidity and introducing a dedicated clearing entity.4 Prior to this, options were primarily traded over-the-counter with varying terms. The standardization enabled a more liquid and accessible market for strategies like selling calls, including the naked call.

Key Takeaways

  • A naked call involves selling a call option without owning the underlying shares.
  • The maximum profit for a naked call seller is limited to the premium received.
  • The potential loss for a naked call seller is theoretically unlimited.
  • This strategy is considered highly risky and is typically undertaken by experienced traders with a bearish or neutral outlook on the underlying asset.
  • Selling naked calls requires a margin account and significant collateral.

Formula and Calculation

The profit or loss for a naked call position is calculated based on the premium received, the strike price of the option, and the price of the underlying asset at expiration.

Maximum Profit:
The maximum profit for a naked call is simply the premium received by the seller. This occurs if the option expires worthless (i.e., the underlying asset's price is at or below the strike price at expiration date).

Maximum Profit=Premium Received\text{Maximum Profit} = \text{Premium Received}

Breakeven Point:
The breakeven point is the price of the underlying asset at which the seller neither profits nor loses. Above this point, the seller begins to incur losses.

Breakeven Point=Strike Price+Premium Received\text{Breakeven Point} = \text{Strike Price} + \text{Premium Received}

Profit/Loss at Expiration:
The profit or loss depends on where the underlying asset's price ($S_T$) is relative to the strike price ($K$) at expiration.

  • If ( S_T \le K ):
    Profit=Premium Received\text{Profit} = \text{Premium Received}
  • If ( S_T > K ):
    Profit/Loss=Premium Received(STK)\text{Profit/Loss} = \text{Premium Received} - (S_T - K)

Interpreting the Naked Call

A naked call position reflects a strongly neutral to bearish outlook on the underlying asset. The seller believes that the price of the underlying asset will either fall, remain flat, or increase only slightly, staying below the strike price by the option's expiration. If the price remains below the strike price, the option expires worthless, and the seller keeps the entire premium. However, if the price rises significantly above the strike price, the seller faces substantial losses as they would be obligated to sell shares they do not own at the strike price, which must then be purchased at the higher market price. This strategy is highly sensitive to changes in volatility, with increasing volatility generally being detrimental to the naked call seller.

Hypothetical Example

Consider an investor who believes that Company XYZ's stock, currently trading at $100, will not rise significantly in the next month. They decide to sell a naked call option with a strike price of $105 expiring in one month, receiving a premium of $2 per share. Since one options contract typically represents 100 shares, the total premium received is ( $2 \times 100 = $200 ).

  • Scenario 1: XYZ stock closes at $104 at expiration.
    Since $104 is below the $105 strike price, the call option expires worthless. The investor keeps the entire premium of $200. This is the maximum profit.

  • Scenario 2: XYZ stock closes at $107 at expiration.
    The option is in the money. The investor is obligated to sell shares at $105 that they do not own. They must buy these shares at the market price of $107.
    Loss from exercising = ( ( $107 - $105 ) \times 100 = $200 )
    Net Profit/Loss = Premium received - Loss from exercising = ( $200 - $200 = $0 ) (Breakeven point is ( $105 + $2 = $107 )).

  • Scenario 3: XYZ stock closes at $115 at expiration.
    The option is deep in the money.
    Loss from exercising = ( ( $115 - $105 ) \times 100 = $1,000 )
    Net Profit/Loss = Premium received - Loss from exercising = ( $200 - $1,000 = -$800 )
    As the stock price continues to rise, the losses for the naked call seller escalate rapidly and theoretically without limit.

Practical Applications

Selling a naked call is primarily used by experienced traders or institutional investors who seek to generate income from the premium when they anticipate the underlying asset's price will remain flat or decline. It is not typically employed for hedging purposes due to its inherent risk profile. Instead, it is a speculative strategy used to capitalize on time decay and declining volatility. This strategy is prevalent in highly liquid options markets where bid-ask spreads are tight, allowing for efficient entry and exit. The use of highly speculative options strategies, including naked calls, can contribute to significant market movements, as seen during periods of increased retail trading activity.3

Limitations and Criticisms

The primary limitation and criticism of the naked call strategy is its theoretically unlimited loss potential. While the maximum profit is capped at the premium received, there is no upper limit to how high the underlying asset's price can go, leading to potentially catastrophic losses if the market moves sharply against the seller's position. This risk necessitates stringent margin account requirements by brokerage firms and close monitoring by traders. Regulatory bodies like FINRA frequently issue warnings about the substantial risks associated with options trading, particularly strategies involving selling uncovered options.2 Effective risk management is crucial when employing this strategy.

Naked Call vs. Covered Call

The key distinction between a naked call and a covered call lies in whether the seller owns the underlying shares.

FeatureNaked CallCovered Call
Underlying SharesNot owned by the sellerOwned by the seller
Risk ProfileTheoretically unlimited lossLimited loss (downside of stock price below purchase price, minus premium)
ObligationBuy shares in the open market to fulfill obligationSell owned shares if option is exercised
PurposeSpeculation, premium income (high risk)Income generation, modest capital appreciation, partial downside protection

A naked call writer assumes the risk of having to purchase shares at a higher market price to fulfill their obligation if the option is exercised. Conversely, a covered call writer already holds the shares, so their obligation is simply to sell those shares at the strike price, limiting their loss to the difference between the stock's purchase price and the strike price, minus the premium received. The Options Clearing Corporation (OCC) acts as the guarantor for both sides of an options trade, mitigating counterparty risk for all listed options transactions.1

FAQs

Why is a naked call considered so risky?

A naked call is risky because the seller does not own the underlying asset. If the price of the underlying asset rises significantly above the strike price, the seller faces an obligation to buy the shares at the higher market price to deliver them at the lower strike price. This potential loss is theoretically unlimited as there is no cap on how high a stock's price can climb.

Can anyone sell a naked call?

No, typically only experienced investors with a brokerage margin account and a high level of approval for options trading can sell naked calls. Brokerage firms require significant collateral due to the substantial risk involved, and they often assess an investor's knowledge and financial capacity before granting permission for such strategies.

What is the maximum profit for a naked call?

The maximum profit for selling a naked call is limited to the initial premium received from selling the options contract. This profit is realized if the underlying asset's price remains at or below the strike price until the option's expiration date, causing the option to expire worthless.