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Naked Call Option Definition
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.
A Little More on What is a Naked Call Option
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 won’t 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, let’s 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 won’t 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.
References for Naked Call Option
Academic Research on Naked Call Option
Is It Better to Go Naked on the Street–A Primer on the Options Market, Johnson, H. F. (1979). Notre Dame Law., 55, 7.
The Naked Commodity Option Contract as a Security, Long, J. C. (1973). Wm. & Mary L. Rev., 15, 211.
Naked and Covered in Monte Carlo: A Reappraisal of Option Taxation, Chason, E. D. (2007). Va. Tax Rev., 27, 135. Equity options market and related derivatives can be said to be staggering, covering trillions of dollars worth of assets. This results in taxing these instruments which are important. Also, it is more acute than the importance, by the use of options in the creation of more complex transactions and in avoiding taxes. In considering an equity call option, which does not obligate but entitles its holder to purchase stock both at a set price and time in the future. There’s a way by option theory to break the option down into more fundamental units.
Pricing and hedging capped options, Boyle, P. P., & Turnbull, S. M. (1989). Journal of Futures Markets, 9(1), 41-54.
Option strategies: Good deals and margin calls, Santa-Clara, P., & Saretto, A. (2009). Journal of Financial Markets, 12(3), 391-417. The evidence is provided that frictions, as a result of trading, have an economically important effect on the profitability and execution of option strategies that includes the writing out-of-the-money put options. Particularly, margin requirements, limit the national amount of capital that can be invested in the force investors and strategies to realize losses and close down positions. The economic impact of friction is stronger in cases when the investor tries to write options more aggressively. Although, the effectiveness of margins in reducing counterparty default risk is imposed by friction that limits investors from supplying liquidity to the options market.
Credit risk and the deposit insurance premium: a note, Dermine, J., & Lajeri, F. (2001). Journal of Economics and Business, 53(5), 497-508. Previously, research on market-based evaluation of deposit insurance premia has showcased the bank as risky assets corporate firm and insured liabilities. There was no attempt made to analyze the risk that characterizes bank assets explicitly. The purpose of this paper is to model bank lending explicitly and run the calculation on loan-risk sensitive insurance premia. Bank’s lending function brings up the need to model equity as a ‘capped’ call option. It is shown by a simulation exercise that market-based estimates of deposit insurance premium that ignores the cap lead to significant underestimation.
Selling Naked Options, Penn, D.
(Naked) Short Selling Around Earnings Announcement, Wang, Y. (2016). Basically, short sellers are considered traders that are sophisticated and respond to news and general information both promptly and earnings that are corporate in announcements and contains fresh information and can update what short sellers believe and affect their investment strategies. Abnormally, market reactions to earnings are surprisingly traditional and considered because of mispricing or the overreaction of investors to unexpected corporate news; although mispricing like this is also determined by the operations of the market microstructure. An innovative dataset is used by this paper that includes detailed short sales information and also fails-to-deliver (FTDs).
Taxes and the Pricing of Options, Black, F., & Scholes, M. (1976). The Journal of Finance, 31(2), 319-332.
Option spread and combination trading, Chaput, J. S., & Ederington, L. H. (2002). Available at SSRN 296036. Both spread and combination trading documentation is a major options market for the first time. It is discovered that spreads and combinations collectively account for over 55% of large trades (trades that are 100 or more) in the market for Eurodollar options and almost 75% of the volume of the trade because of large trades. For the total volume, there are four heavily traded combinations, and they are (sequentially): straddles, ratio spreads, vertical spread and strangles. Of all combination trades, these four represents about two-thirds. Condors, guts, horizontal spread, box spreads, covered calls, and synthetics are scarcely traded.
Volatility trade design, Chaput, J. S., & Ederington, L. H. (2005). Journal of Futures Markets: Futures, Options, and Other Derivative Products, 25(3), 243-279. Volatility trades like strangles, straddles and option combination, although these options are seriously traded and discussed in all derivative text and also important to aligning implied volatility trades. These trades have received little attention in the literature concerning finance research. By the usage of a unique data set for the Eurodollar options market, the seven volatility trades are examined which includes straddles, option combinations, strangles, butterflies, guts, iron butterflies and condors. It is further discovered that choices traders make among the seven strategies and their chosen designs for the individual strategy indicates that volatility traders need design.