Options strategy - Short Call

Naked Call Writing (Selling Uncovered Calls)

Investor Sentiment:
Neutral to bearish strategy, high risk. Due to brokerage requirements and loss potential, this strategy is not recommended for most investors.

Profit Potential:
Realize revenue with no cash investment required. The naked (uncovered) call writer (seller of the uncovered call option) realizes profit as long as the stock price does not advance above the call option strike price. If the underlying stock price remains relatively unchanged during the option period, the naked (uncovered) call seller realizes profit.

Risks:
If stock price rises, the naked (uncovered) call seller has unlimited loss potential. It is a risky strategy because one loss can wipe out a number of profitable naked call writes.

Drawbacks:
Limited profit potential, unlimited loss potential. Very high risk.

Naked Call Writing Introduction

One of the most common option strategies is selling or writing calls against a long position in underlying stock. This is also referred to as "covered call writing" (CC). This strategy requires the investor to already own the underlying shares of stock and he/she sells call options against those shares. The only difference between the CC strategy and selling uncovered calls or naked call writing, is the seller of the call options does not own the underlying stock. The uncovered call seller is anticipating that the stock price will stay relatively unchanged or drops during the option period. The benefit to the uncovered call seller is this transaction can be done without any capital investment; the seller can realize a profit without tying up capital necessary to purchase the underlying stock. Realizing profit without investing capital is the strength of this option strategy, but there are some stringent brokerage requirements that must be met in order to do this risky transaction.

So, what are the drawbacks of selling uncovered calls? This strategy is a high risk venture with limited profit and an unlimited loss potential. The uncovered call seller realizes revenue if the stock remains unchanged or decreases during the option period. If the stock price rises past the call option strike price prior to the option expiration date, the uncovered call seller could potentially lose significant investment capital. It was mentioned earlier that this strategy has unlimited loss potential. That is because, in theory, the stock can rise to an infinite price. But in reality, the stock price is measured only through the duration of the option period. Because the time period is limited, the stock price will only increase a certain amount, though this amount could be significant. Therefore, the loss potential is limited but it could be a very significant amount.

Before we look at a naked call writing example, let's review a quote from the "Characteristics and Risks of Standardized Options" pamphlet given to each investor prior to opening an option account:

"The writer of an uncovered call is in an extremely risky position and may incur large losses if the value of the underlying interest increases above the exercise (strike) price. When a physical delivery uncovered call is assigned an exercise, the writer will have to purchase the underlying interest in order to satisfy his/her obligation on the call and the loss will be the excess of the purchase price over the exercise price of the call reduced by the premium received for writing the uncovered call. Anything that may cause the price of the underlying interest to rise dramatically, such as a strong market rally, can cause large losses for the uncovered call writer."

In-The-Money Versus Out-Of-The-Money Naked Calls

There are a number of different terms that describe option strike prices in relation to the stock price. Writing an out-of-the-money naked call has less profit potential, but is a more conservative naked call position than an in-the-money naked write. Because of the high risk involved with in-the-money naked calls, and the risky nature of naked call writing in general, "Sell Naked Calls" data strictly includes only out-of-the-money naked call plays. These aren't our selections or stock picks, but rather is a list of naked call premium percentage returns (starting with the highest) against all trading options each day and lists them to show a naked call writer the option premium that can be realized if the investor sells the out-of-the-money uncovered call option. One should review their risk versus reward criteria before executing any naked or uncovered call position.

In-The-Money:
This term refers to a call option strike price that is lower than the current stock price. For example, if a naked call writer sells a call that is the May $10 strike price against a stock that is currently priced at $12.50, this would be considered an in-the-money naked call position.

At-The-Money:
This describes a call option strike price and a stock price that are the same. For example, if the naked call writer sells a call that is the May $10 strike price against a stock that is currently priced at $10, this would be considered an at-the-money naked call position.

Out-Of-The-Money:
This call option position is the most conservative of the three positions for naked call writing, but has the least profit potential. Because the call option strike price is slightly higher than the stock price, the naked call writer can realize a profit if the stock price remains relatively unchanged or decreases through the option expiration date. The option premium will not be as large as an in-the-money or at-the-money position, but it provides the naked call writer the least loss potential. Again, the "Sell Naked Calls" data only provides out-of-the-money uncovered call plays.