Naked call
Encyclopedia
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 stock falls to zero. A naked call is the opposite of a covered call
.
The buyer of a call option
has the right to buy a specific number of shares at a strike price
before an expiration date from the call option seller. Since a naked call seller does not have the stock in case the option buyer decides to exercise his option, he has to buy stock
at the open market
in order to deliver it at the strike price. Since the share price has no limits to how far it can rise, the naked call seller is exposed to unlimited risk.
DEC 50 Call is trading at $1.25 premium
Investor A forecasts that XYZ will not trade above $50 per share before December, so he sells the 10 DEC 50 Calls for $1,250 (each option contract controls 100 shares). Investor A doesn't buy the stock, therefore his investment is considered naked.
Meanwhile, Investor B forecasts that XYZ will go above $50, so he purchases those 10 calls from Investor A for $1,250. At expiration of the option, consider 4 different scenarios where the share price drops, stays the same, rises moderately or surges.
The following are four scenarios for the example:
DEC 50 Call expires worthless
Investor A keeps the entire premium of $1,250
Investor B makes a 100% loss
DEC 50 Call expires worthless
Investor A keeps the entire premium of $1,250
Investor B makes a 100% loss
DEC 50 Call is exercised
Investor A is forced to buy 1,000 shares of XYZ for $52,450 and immediately sell them at $50,000 for a loss of $2,450. Since he received the premium of $1,250 before, his net loss is $1,200.
Investor B buys 1,000 shares of XYZ for $50,000 and now is able to sell them at open market for $52.45 per share if he chooses to. His net gain is $1,200 (same as Investor A's loss excluding commission costs)
DEC 50 Call is exercised
Investor A is forced to buy 1,000 shares of XYZ for $75,000 and immediately sell them at $50,000 for a loss of $25,000. Since he received the premium of $1,250 before, his net loss is $23,750
Investor B buys 1,000 shares of XYZ for $50,000 and now is able to sell them at open market for $75.00 per share if he chooses to. His net gain is $23,750 (same as Investor A's loss excluding commission costs)
Options strategies
Options strategies can favor movements in the underlying that are bullish, bearish or neutral. In the case of neutral strategies, they can be further classified into those that are bullish on volatility and those that are bearish on volatility...
because it carries unlimited risk as opposed to a naked put
Naked put
A naked put is a put option where the option writer does not have a position in the underlying stock or other instrument. This strategy is best used by investors who want to accumulate a position in the underlying stock - but only if the price is low enough...
where the maximum loss occurs if the stock falls to zero. A naked call is the opposite of a covered call
Covered call
A covered call is a financial market transaction in which the seller of call options owns the corresponding amount of the underlying instrument, such as shares of a stock or other securities. If a trader buys the underlying instrument at the same time as he sells the call, the strategy is often...
.
The buyer of a call option
Call option
A call option, often simply labeled a "call", is a financial contract between two parties, the buyer and the seller of this type of option. The buyer of the call option has the right, but not the obligation to buy an agreed quantity of a particular commodity or financial instrument from the seller...
has the right to buy a specific number of shares at a strike price
Strike price
In options, the strike price is a key variable in a derivatives contract between two parties. Where the contract requires delivery of the underlying instrument, the trade will be at the strike price, regardless of the spot price of the underlying instrument at that time.Formally, the strike...
before an expiration date from the call option seller. Since a naked call seller does not have the stock in case the option buyer decides to exercise his option, he has to buy stock
Stock
The capital stock of a business entity represents the original capital paid into or invested in the business by its founders. It serves as a security for the creditors of a business since it cannot be withdrawn to the detriment of the creditors...
at the open market
Open market
The term open market is used generally to refer to a situation close to free trade and in a more specific technical sense to interbank trade in securities.-Use of the term in economic theory:...
in order to deliver it at the strike price. Since the share price has no limits to how far it can rise, the naked call seller is exposed to unlimited risk.
Examples
Stock XYZ is trading at $47.89 per shareDEC 50 Call is trading at $1.25 premium
Investor A forecasts that XYZ will not trade above $50 per share before December, so he sells the 10 DEC 50 Calls for $1,250 (each option contract controls 100 shares). Investor A doesn't buy the stock, therefore his investment is considered naked.
Meanwhile, Investor B forecasts that XYZ will go above $50, so he purchases those 10 calls from Investor A for $1,250. At expiration of the option, consider 4 different scenarios where the share price drops, stays the same, rises moderately or surges.
The following are four scenarios for the example:
Scenario 1
Stock drops to $43.25DEC 50 Call expires worthless
Investor A keeps the entire premium of $1,250
Investor B makes a 100% loss
Scenario 2
Stock stays at $47.89DEC 50 Call expires worthless
Investor A keeps the entire premium of $1,250
Investor B makes a 100% loss
Scenario 3
Stock rises to $52.45DEC 50 Call is exercised
Investor A is forced to buy 1,000 shares of XYZ for $52,450 and immediately sell them at $50,000 for a loss of $2,450. Since he received the premium of $1,250 before, his net loss is $1,200.
Investor B buys 1,000 shares of XYZ for $50,000 and now is able to sell them at open market for $52.45 per share if he chooses to. His net gain is $1,200 (same as Investor A's loss excluding commission costs)
Scenario 4
Stock surges to $75.00 on a news announcementDEC 50 Call is exercised
Investor A is forced to buy 1,000 shares of XYZ for $75,000 and immediately sell them at $50,000 for a loss of $25,000. Since he received the premium of $1,250 before, his net loss is $23,750
Investor B buys 1,000 shares of XYZ for $50,000 and now is able to sell them at open market for $75.00 per share if he chooses to. His net gain is $23,750 (same as Investor A's loss excluding commission costs)