Imagine watching someone jump out of a plane without a parachute.
It’s a bit unsettling, right? Well, the same could be said about a naked call.
We’ve all heard the saying that the higher the risk, the higher the reward. Many times with extreme sports like skydiving, the reward is the sheer thrill. But how does this relate to options trading and naked calls?
Well, employing a naked call strategy is basically like jumping out of a plane without a parachute. You have no protection, the risk is literally infinite, but the reward is what investors seek.
Buckle in for a deep dive on naked calls so that it’s clear why traders might choose to take on this high-risk strategy — and what precautions they should consider before doing so.
What you’ll learn
Quick Refresher on Call Options
Alright, let’s not run before we walk here. Naked calls are a fairly complex strategy, so it’s a good idea to understand the underlying mechanics involved first.
Calls are the foundation of naked calls. So as a quick refresher, a call is one of two types of options contracts that represent 100 shares of the underlying asset, and gives the owner of the call the right – but not the obligation – to sell the underlying asset at a set price (strike price) before a specific date (the contract’s expiration date). When you buy a call, it’s considered a bullish strategy – you think the price of the underlying stock will increase.
Now, when a call option is sold, the seller, also known as the writer, takes on the obligation to sell the underlying asset at the strike price if the buyer decides to exercise the option. In the case of a call, the term ‘exercise’ just means using the right to purchase 100 shares at the strike price. When the seller of the call option doesn’t own the underlying asset, it’s referred to as a naked call.
So, What Exactly is a Naked Call?
Well, we already know that they’re risky and they involve selling a call, but how do they work, and why are they called “naked”?
When an investor sells a naked call, they’re hoping that the price of the underlying stock will not rise above the strike price. But, in the case that it does rise above the strike price, the investor who sold the call might have to sell the underlying stock at a loss if the call is exercised by the buyer. And that loss has the potential to be unlimited, in theory.
Wait what? Yes, unfortunately, and in theory, you take on an infinite level of risk if you use a naked call. This is because if the stock price keeps rising above the strike price, it might start to make sense for the buyer to act on their option and buy the stock at the strike price. In that unfortunate case, the seller would be obligated to sell the stock at a loss, and that loss could be quite hefty, even unlimited in the worst-case scenario.
Investors can avoid this level of risk by employing a technique called hedging. Hedging is essentially counterbalancing one investment with another, to hopefully reduce potential losses and also reduce risk. In the case of naked calls, hedging can involve purchasing shares of the underlying asset or purchasing a call option. That way if things go south with the naked call, the simultaneous ownership of a bullish position can offset the rising stock price. Here’s a good rule of thumb: like increases like, opposites balance.
Without hedging the sold call, it’s exposed to the wrath of the market, hence, “naked”. Otherwise it would be referred to as a “covered” call.
In the above diagram, we can see that if the underlying price of the naked call continues to increase, it will eventually break even and then create a loss.
Understanding the Ins and Outs of Naked Calls
With a good grasp of the basic concept of the naked call strategy, let’s dive a little deeper. There are a few important considerations that traders need to be aware of.
If the losses with the strategy have the potential to be so significant, investors either need to have a lot of capital on hand to cover a potential loss, or a margin account, which is an account that allows investors to borrow money from their brokerage.
Another thing to consider is that naked calls are almost always a short-term play. The more time that passes, the higher the probability that the price will move in an unfavorable direction. This notion is referred to as ‘time decay’, and it’s measured through an option’s Theta. At the same time, the seller of the call is working against the clock, as all options have an expiration date, so oftentimes it feels safer for an investor to just close the position after it reaches profitability.
Lastly, let’s see how implied volatility (IV) affects naked call positions. Implied volatility essentially refers to the market’s expectation of how much an underlying asset’s price will fluctuate over time, and it plays an integral role in the pricing of options.
In the case of naked calls, higher implied volatility can increase the premium received by the seller because higher implied volatility means it has a chance to swing in the seller’s favor, which can make the strategy more attractive. However, higher implied volatility also means that the stock price is expected to fluctuate more, increasing the risk of incurring substantial losses.
Conversely, lower implied volatility can reduce the premium received by the seller, making the strategy less attractive. But, it also means that the stock price is expected to fluctuate less, which can reduce the risk of losses.
We’ve covered so far what exactly naked calls are, as well as what to consider before trading them. Now it’s time to get into how to trade them, and what key points investors should be aware of when they’re thinking about trading them.
Trading Naked Calls
At this point we’re well aware that naked calls are risky – so why are they used, and how?
Experienced options traders consider naked calls a viable strategy to capitalize on short-term price movements. But to make the most of this strategy, it’s important to have a solid plan in place.
You’ll hear the term “write” when selling options, and “writing” is just another way of saying “selling” (at least in the world of options), so an investor will sell a call option contract for a specific stock at a specific strike price and expiration date.
After you write, or sell a call, the seller will immediately be credited the premium from the buyer of the call. The goal as the seller, again, is to make sure that they hold onto as much of the premium as possible. If the stock price remains below the strike price, the seller keeps the premium and the option expires. But if the stock price rises above the strike price, the seller must purchase the stock at the higher market price and sell it to the buyer at the lower strike price, resulting in a loss.
If at any point you want to close the position, perhaps to save from larger losses, or to lock in profit, the investor who sold the call can simply buy it back, which means they are no longer obligated to sell the stock. This can be done at any time before the expiration date. If the seller has made a profit on the premium received, they can buy back the call option for less than they sold it for and keep the difference as profit.
The last thing we want to cover before getting into some specific tips are, what exactly the max gain and break even point of naked calls are. We know that max loss is unlimited. The break-even point of naked calls is when the premium received equals the cost of the losses incurred if the underlying asset’s price rises above the strike price. Lastly, max gain is limited to the premium received initially from the buyer.
In addition to the important details of trading naked calls, here are some helpful tips to guide you further:
- Firstly, only sell naked calls associated with stocks that you are willing to buy at the strike price, as you may be forced to purchase the underlying stock at a higher market price. Don’t just shoot a shotgun hoping to hit a target somewhere, or rather, anywhere. Take time and care, and snipe the one that you want in the case that you have to sell the stock.
- Use stop-loss orders to limit potential losses if the stock price rises above the strike price. Using stop-loss orders is like having an extra set of eyes on your positions. They’re especially useful for those that have other responsibilities like a day job and or a family.
- Diversify your portfolio and avoid over-reliance on naked call trading to limit your exposure. As the saying goes, don’t put all your eggs in one basket.
- Have a solid exit strategy in place, and be willing to cut your losses if the market conditions change. This means setting a bottom line for yourself, and being disciplined, especially if the trade starts to not go in your favor. Most of the time you’ll save money in the long run.
- Keep a close eye on market conditions and the stock’s price movement to avoid being caught off guard by sudden price changes. This may seem obvious, but beware, options can fluctuate like crazy, this is one of the reasons it’s a good idea to set a stop-loss order. Implied volatility plays a huge role in the magnitude of fluctuation. Another avenue is subscribing to trade alert services from a team of options trading analysts to be notified of significant market moves. Whichever path you take – be vigilant!
An Example of a Naked Call
The best way to fully ensure your understanding of a naked call is to walk through an example.
Let’s say someone sells a call of Tesla (TSLA) with a strike price of $150. So they’re selling the right to purchase 100 shares of TSLA at $150 per share to someone who buys the call.
If the stock price remains below $150, it wouldn’t make sense for the buyer to exercise their right to buy the shares, so the seller will keep the premium (price paid for the option) as profit. If the premium was $5.00 per share, for example, the trader would profit $500.
However, if TSLA’s price rises above $150, the buyer may choose to exercise their right to buy the shares, and then the seller would have to sell the shares at that price, even if the current price is higher. This means the seller will have to buy the shares at a higher price to fulfill the terms of the contract, ultimately resulting in a loss.
So for example, if TSLA’s price rises to $160, the seller would have to buy the shares at $160 and sell them for $150, resulting in a loss of $1,000.
With this example you can start to see that while it may seem relatively easy to keep the premium and just scrape up some profits, you can also clearly see that you can easily take a big hit. This is the nature of naked calls.
Conclusion
To wrap things up, naked calls are indeed like jumping out of an airplane without a parachute.
While naked calls can offer the potential for high profits, they are a high-risk strategy that need to be proceeded with caution. If the stock price rises above the strike price, the seller can be obligated to purchase the stock at the higher market price and sell it at the lower strike price, resulting in a loss.
Overall, while the potential for high profits may be tempting, investors should carefully consider the risks involved before pursuing a naked call strategy. Taking the time to thoroughly research the specific stock and market can help minimize risk and maximize potential profits.
Naked Calls in Options Trading: FAQs
What Types of Risks Come With Using Naked Calls as an Option Strategy?
Naked calls come with several risks. The primary risk is unlimited loss potential if the underlying asset’s price rises above the call option’s strike price. Additionally, naked call sellers face margin requirements and potential margin calls if the price of the underlying asset rises sharply. Naked calls also have a higher probability of expiring worthless, which can result in losses for the seller.
How Do Naked Calls Differ From Covered Calls in Terms of Option Strategy?
A naked call is an option strategy where an investor sells a call option without owning the underlying asset. In contrast, a covered call involves selling a call option while also owning the underlying asset. The underlying asset in a covered call acts as collateral and limits the seller’s potential losses.
What Criteria Should I Use to Evaluate Whether Naked Calls Align With my Investment Strategy?
Investors should carefully consider their risk tolerance, investment objectives, and level of experience before deciding to use naked calls. Naked calls can be a suitable strategy for investors who are willing to take on higher risks for the potential of higher returns.
Many times investors will learn what works and what does not work for their strategy after some trial and error. That’s why it is a good idea to give your investment strategy at least 3 months to become profitable. If that sounds like too much of a risk, then first try the strategy out with a demo account where you can test various trading strategies risk-free.
Which Factors Should I Take Into Account When Determining Whether Naked Calls Are Appropriate For My Investment Goals?
Investors should consider several factors before deciding whether or not to use naked calls. Including the underlying stock’s volatility and price movements, the option’s strike price and expiration date, the investor’s risk tolerance and investment objectives, and the potential for margin requirements and margin calls.
