Naked call
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A naked call occurs when a speculator writes (sells) a call option on a security without ownership of that security. It is one of the riskiest options strategies because it carries unlimited risk as opposed to a naked put, where the maximum loss occurs if the underlying falls to zero (assuming it cannot reach a negative price). A naked call is similar to a covered call in that the trader is selling the call option for an initial premium, however unlike the covered call, they do not own the corresponding amount of stock.
The buyer of a call option has the right to buy a specific number of shares from the call option seller at a strike price at an expiration date (European Option). Since a naked call seller does not have the stock in case the option buyer decides to exercise the option, the seller has to buy stock at the open market in order to deliver it at the strike price. Since the share price has no limit to how far it can rise, the naked call seller is exposed to unlimited risk.
Speculators who have an appetite for risk might buy a call option when they believe the price of the stock will go up and they do not have the cash available to pay for the stock at its current price. A disadvantage of the call option is that it eventually expires.
Speculators may sell a "naked call" option if they believe the price of the stock will decline or be stagnant.[1]
Examples[]
Stock XYZ is trading at $47.89 per share DEC 50 Call is trading at $1.25 premium
Investor A ("A") forecasts that XYZ will not trade above $50.00 per share before December, so A sells the 1 DEC 50 Call for $125.00 (each option contract controls 100 shares). A doesn't buy the stock, therefore A's investment is considered naked.
Meanwhile, Investor B ("B") forecasts that XYZ will go above $50.00 per share before December, so B purchases the call from A for $125.00. At expiration of the option, consider 4 different scenarios where the share price drops, stays the same, rises moderately or surges.
Assuming there are no other costs or taxes affecting the contract, when A) the date is December 31 or B) prices rise above $50.00, one of two general things happen: 1) B makes a 100% loss, 2) B profits by the same amount of A's net loss.
The following are four scenarios for the example:
Scenario 1[]
Stock drops to $43.25, DEC 50 Call expires worthless.
A keeps the entire premium of $125.00; B makes a 100% loss.
Scenario 2[]
Stock stays at $47.89, DEC 50 Call expires worthless.
A keeps the entire premium of $125.00; B makes a 100% loss.
Scenario 3[]
Stock rises to $52.45, DEC 50 Call is exercised.
A is forced to buy 100 shares of XYZ for $5,245.00 and immediately sell them at $5,000.00 for a loss of $245.00. Since A received the premium of $125.00 before, A's net loss is $120.00. B buys 100 shares of XYZ for $5,000.00 and now is able to sell them at open market for $52.45 per share, if B so chooses. B's net gain is $120.00 (same as A's loss excluding commission costs)
Scenario 4[]
Stock surges to $75.00 on a news announcement. DEC 50 Call is exercised.
A is forced to buy 100 shares of XYZ for $7,500.00 and immediately sell them at $5,000.00 for a loss of $2,500.00. Since A received the premium of $125.00 before, A's net loss is $2,375.00. B buys 100 shares for $5,000.00 and paid the premium of $125.00 before. These shares are now worth $7,500.00 on the open market. B's net gain is $2,375.00 (same as A's loss, if commission costs are omitted).
References[]
- ^ Juggernaut (2012-07-12). "When to Use A Naked Call Option". Archived from the original on 2013-07-10.
- Options (finance)