Out-Of-The-Money Naked Call Explained

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Out-Of-The-Money Naked Call

The out-of-the-money naked call strategy involves writing out-of-the-money call options without owning the underlying stock. It is a premium collection options strategy employed when one is neutral to mildly bearish on the underlying.

Naked Call (OTM) Construction
Sell 1 OTM Call

The main objective of writing naked calls is to collect the premiums when the options expire worthless. One would write an out-of-the-money naked call every month and if the stock price stays flat or drops, one would pocket the premiums and repeat the process as long as the perceived market condition remains unchanged.

Limited Profit Protential

Maximum gain is limited and is equal to the premium collected for selling the call options.

The formula for calculating maximum profit is given below:

  • Max Profit = Premium Received – Commissions Paid
  • Max Profit Achieved When Price of Underlying

Unlimited Loss Potential

If the stock price goes up dramatically at expiration, the out-of-the-money naked call writer will be required to satisfy the options requirements to sell the obligated stock to the options holder at the lower strike price by buying the stock from the open market at the higher market price. Since there is no limit to how high the stock price can be at expiration, maximum potential losses for writing out-of-the-money naked calls is therefore theoretically unlimited.

The formula for calculating loss is given below:

  • Maximum Loss = Unlimited
  • Loss Occurs When Price of Underlying > Strike Price of Short Call + Premium Received
  • Loss = Price of Underlying – Strike Price of Short Call – Premium Received + Commissions Paid

Breakeven Point(s)

The underlier price at which break-even is achieved for the naked call (otm) position can be calculated using the following formula.

  • Breakeven Point = Strike Price of Short Call + Premium Received

Example

The stock XYZ is currently trading at $48. An options trader decides to writes a JUL 50 out-of-the-money naked call for $3. So he receives $300 for writing the call option.

On expiration date, the stock had rallied to $68. Since the striking price of $50 for the call option is lower than the current trading price, the call is assigned and the writer buys the shares for $6800 and sell it to the options holder at $5000, resulting in a loss of $1800. However, since he received $300 earlier on, his net loss is $1500.

However, what happens should the stock price had gone down 20 points to $28 instead? Let’s take a look.

At $28, the call expires worthless and the writer of the naked call keeps the $300 in premiums received as profit.

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From the profit graph above, we can see that the breakeven is at $53 (Call Strike + Premium). So long as the stock price remains at $53 or below, the naked call writer will not suffer any loss.

In-the-money Naked Call Write

A more bearish version of this strategy with a higher potential profit is to write deep-in-the-money naked calls.

Note: While we have covered the use of this strategy with reference to stock options, the naked call (otm) is equally applicable using ETF options, index options as well as options on futures.

Commissions

For ease of understanding, the calculations depicted in the above examples did not take into account commission charges as they are relatively small amounts (typically around $10 to $20) and varies across option brokerages.

However, for active traders, commissions can eat up a sizable portion of their profits in the long run. If you trade options actively, it is wise to look for a low commissions broker. Traders who trade large number of contracts in each trade should check out OptionsHouse.com as they offer a low fee of only $0.15 per contract (+$4.95 per trade).

Similar Strategies

The following strategies are similar to the naked call (otm) in that they are also bearish strategies that have limited profit potential and unlimited risk.

Naked Call

What is a Naked Call?

A naked call is an options strategy in which an investor writes (sells) call options on the open market without owning the underlying security. This stands in contrast to a covered call strategy, where the investor owns the underlying security on which the call options are written. This strategy is sometimes referred to as an “uncovered call” or a “short call.”

Understanding Naked Call

A naked call gives an investor the ability to generate revenue without actually owing the underlying security. Essentially, the premium received is the sole motive for writing an uncovered call option. It is inherently risky as there is limited upside profit potential and, in theory, unlimited downside loss potential.

  • The maximum gain is the premium that the option writer receives upfront, which is usually credited to their account. So, the goal for the writer is to have the option expire worthless.
  • The maximum loss is theoretically unlimited because there is no cap on how high the price of the underlying security can rise. However, in more practical terms, the seller of the options will likely buy them back well before the price of the underlying rises too far above the strike price, based on his/her risk tolerance and stop-loss settings.
  • The breakeven point for the writer is calculated by adding the premium received and the strike price for the naked call.
  • A rise in implied volatility is not desirable to the writer as the probability of the option being in-the-money, and thus being exercised, also increases.
  • Since the option writer wants the naked call to expire out-of-the-money, the passage of time, or time decay, will have a positive impact on this strategy.
  • Margin requirements, understandably, tend to be quite steep given the unlimited risk potential of this strategy.

As a result of the risk involved, only experienced investors who strongly believe that the price of the underlying security will fall or remain flat should undertake this advanced strategy. The margin requirements are often very high for this strategy due to the propensity for open-ended losses, and the investor may be forced to purchase shares on the open market prior to expiration if margin thresholds are breached. The upside to the strategy is that the investor could receive income in the form of premiums without putting up a lot of initial capital.

Key Takeaways

  • A naked call is an options strategy in which the investor writes (sells) call options without owning the underlying security.
  • A naked call has limited upside profit potential and, in theory, unlimited downside loss potential.
  • A naked call’s breakeven point for the writer is its strike price plus the premium received.

Using Naked Calls

Again, there is significant risk of loss with writing uncovered calls. However, investors who strongly believe the price for the underlying security, usually a stock, will fall or stay the same can write call options to earn the premium. If the stock stays below the strike price between the time the options are written and their expiration date, then the options writer keeps the entire premium minus commissions.

If the price of the stock rises above the strike price by the options expiration date then the buyer of the options can demand the seller to deliver shares of the underlying stock. The options seller will then have to go into the open market and buy those shares at the market price to sell them to the options buyer at the options strike price. If, for example, the strike price is $60 and the open market price for the stock is $65 at the time the options contract is exercised, the options seller will incur a loss of $5 per share of stock less the premium received..

Naked Call Writing: A High Risk Options Strategy

In options terminology, “naked” refers to strategies in which the underlying security is not owned and options are written against this phantom security position. The naked strategy is aggressive and higher risk but can be used to generate income as part of a diversified portfolio. However, if not used properly, a naked call position can have disastrous consequences since a security can theoretically rise to infinity.

Key Takeaways

  • A ‘naked call writer’ is somebody who sells call options without owning the underlying asset or trading other options to create a spread or combination.
  • The naked call writer is effectively speculating that price of the underlying asset will go down.
  • The naked call seller is exposed to potentially unlimited losses, but only limited upside potential – that being the price of the option’s premium.

How To Write Naked Calls

Naked call writing is the technique of selling a call option without owning the underlying security. Being long a call means you have the right to buy the security at a fixed price. On the other side of the transaction, the counterparty who sold the call is said to be “short” the call, and his or her position can either be secured by underlying ownership (covered call) or unsecured (naked call). This might be confusing so here’s a diagram that summarizes these relationships:

Thus, naked calls are one means of being short a call. This is typically a more advanced level of options trading since there are greater risks. In fact, the broker may not permit the position until the account holder meets stringent criteria i.e. large margin account and/or years of experience.

When selling a naked call, you instruct the broker to “sell to open” a call position. Since you do not have an underlying position, you will be forced to buy the security at the market price and sell at the strike price if those calls go in-the-money.

Many investors aren’t sure if being “short a call” and “long a put” are the same thing. Intuitively, this makes sense because calls and puts are almost opposite contracts but they aren’t the same thing. When you are long a put, you have to pay the premium and the worst case scenario will result in premium loss and nothing else. However, when you are short a call, you collect the premium but are exposed to greater risk, which is discussed below.

Risks and Rewards

A naked call is much riskier than writing a covered call because you have sold the right to something that you do not own. The closest parallel in the equity world is shorting a stock, in which case you borrow the stock you are selling. When writing naked calls, you sell the right to buy the security at a fixed price; aiming to make a profit by collecting the premium.

Assume that ABC stock trades for $100 and the $105 call with one month to expiration trades at $2. You can sell (write) a naked call for $2 and collect $200 in option premium. In doing so, you are speculating that ABC stock will be below $107 ($105 + $2 premium) at expiration. i.e. you make a profit if is below $107.

Consider the payoff diagram:

As you can see, losses mount quickly as the price of the stock goes above the $107 breakeven price. Also note that, at any price below $105, the profit for the seller of the option remains at $200, which is the received premium. The naked call writer is faced with the unattractive prospect of a limited profit and a seemingly limitless loss. You can now see why brokers may restrict access to this options strategy.

It is important to note that, since a naked call position carries major risk, investors typically offset part of the risk by purchasing another call or some underlying security.

Closing Out Naked Calls

In the above example, you need to consider whether the ABC option is in or out of the money before closing the position.. If the call is out of the money, you can buy back the call option at a cheaper price. If the call is in the money, you can a) buy back the call option at a higher price or b) buy shares to offset the call.

In both cases, your downside is protected.

The Bottom Line

Writing a naked call is an options strategy that carries significant risks because the security can move higher. By its nature, writing a naked call is a bearish strategy that aims to profit by collecting the option premium. Due to the risks, most investors hedge their bets by protecting some downside with securities or other call options at higher strike prices.

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