Depending on whether the investor is buying or selling, a naked call is a high-risk manoeuvre where investors sell (or buy) call options without owning the underlying stock, essentially betting on the stock price rising or declining, depending on whether the investor is long or short the call.
When an investor sells (buys) a naked call, they grant the buyer (themselves) the right to purchase a stock at a specific price within a certain timeframe. The seller receives a premium from the buyer for this option. If the stock price does not exceed the strike price by the option’s expiration date, the seller’s profit is the premium. This strategy is predicated on the belief that the stock will not rise above the strike price, allowing the seller to keep the entire premium when the option expires worthless. While the buyer has the belief that the price with exceed the strike price, allowing the buyer to buy the stock for cheaper than market value, profiting from the difference between the strike price – share price – option premium.
Pros of Naked Call Selling:
Income Generation: The primary allure of selling naked calls is the immediate income from the premiums collected when the options are sold.
High Return on Investment: Since the only capital required is the margin to cover the trade, the return on investment can be significant if the stock price remains stagnant or drops.
Flexibility: It allows investors to profit from a neutral to bearish market outlook without needing to own or purchase the underlying stock.
Cons of Naked Call Selling:
Unlimited Loss Potential: If the investor sells a naked call option and the stock price surges above the strike price, the seller must supply the shares at a potentially much lower price than the current market price, leading to significant losses.
Margin Calls: As the potential for loss is unlimited, there may be substantial margin requirements to hold the position open, which can tie up capital.
Market Volatility: The strategy is particularly vulnerable to unexpected market rallies which can result in steep losses.
An investor who sells a naked call with a strike price of $100, receives a premium of $5 per share. If the stock trades below $100 at expiration, the investor profits by $5 per share. However, if the stock unexpectedly climbs to $150, the investor is obligated to deliver the shares at $100, resulting in a loss of $45 per share ($50 minus the $5 premium), a reminder of the inherent risks of this strategy.
Naked Call Selling Diagram