Naked Call Option - Explained
What is a Naked Call Option?
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Table of ContentsWhat is a Naked Call Option?How Does a Naked Call Option Work?
What is a Naked Call Option?
A naked call is a call option strategy where a speculator or investor writes (sells) a call option on a security without having the ownership on that underlying security. It is a very risky option strategy as opposed to the covered call strategy where the investor writes a call option on a security on which he or she has the ownership right. In naked call strategy, the investor simply sells a call option without owning the underlying stock itself. Here the call option is sold naked without the underlying units.
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How Does a Naked Call Option Work?
Writing Call Options is a strategy with a high risk attached to it. If the price of the underlying stock rises above the strike price, the investor will have to incur a loss. If the price remains the same or decreases from the strike price the investor earns a profit without investing a lot of initial capital. For example, let's say Raymond strongly believes the price of stocks of X wont exceed $80 per share for the next six months. So, he engages in a naked call strategy and writes a call options on 100 shares of X with a strike price of $80 per share with an expiration date of six months from now. There are two possible consequences for this strategy. (i) The price of the underlying stock exceeds the strike price within six months. In this case, lets assume price rises to $90 per share. Then the option will be exercised, and Raymond will have to buy the shares from the open market with $90 per shares. So, he will lose $10 per share. As there is no cap on how much the price may increase the potential for the loss is unlimited. (ii) The price remains $80 per share or lower. The option wont be exercised, and Raymond gets to keep the whole amount he collected as. Theoretically, the potential of maximum loss is unlimited in a naked call strategy as there is no cap on the price rise of the underlying shares. But in reality, the investors purchase the shares much ahead the stock reaches the strike price to avoid a loss. In reality, the investor buys back the options much ahead of the time when the price of the underlying rises above the strike price depending on his or her risk tolerance. Generally, only the experienced investors take this risk in order to earn a profit in form of premiums without investing a lot of initial capital. They take this strategy only when they are sure the price of the underlying security will fall or remain the same. Still, the risk factor is very high as no one can surely predict the movement of the prices of the underlying securities. As the writer doesn't already own the stocks, so if the option is exercised the investor must purchase the stock at a prevailing market price in order to deliver them. The summation of the strike price and the premium is the breakeven point for a naked call option.