A naked call is an advanced strategy where an investor sells call options without owning the asset. It can be profitable if the stock stays below the strike price but carries unlimited risk when the price rises. Given the complexity of options trading, consulting with a financial advisor can help you develop a strategy based on your risk level.
What Is a Naked Call?
Options trading offers investors a range of strategies to generate income, hedge positions or speculate on price movements. An investor using the naked call strategy writes or sells a call option without owning the underlying security.
This strategy provides immediate premium income with little capital investment but is also very risky. If the asset price rises sharply, the seller must deliver shares at the strike price, leading to potentially unlimited losses.
Since losses can be unlimited, this strategy needs careful risk management. Using stop-loss orders or hedging with protective options can limit risk but also reduce potential profits.
Brokerages often restrict naked call trading due to its high risk. Investors should fully understand how it works before using this strategy.
How Does a Naked Call Options Strategy Work?
A naked call strategy involves selling call options, expecting the stock to stay below the strike price until expiration. The seller earns premium income but faces high risk if the stock price rises since they don’t own the shares.
Here are three general things you should know about how this strategy works:
- Selling a call option.The trader sells a call option on a stock they don’t own and collects an upfront premium, which depends on factors like stock price, strike price, and time to expiration.
- Waiting for expiration. If the stock price stays below the strike price until expiration, the option expires worthless, and the seller keeps the premium as profit.
- Risk of assignment.If the stock price rises above the strike price, the buyer exercises the option, forcing the seller to buy shares at market price and sell them at the lower strike price, leading to potential losses.
Example of a Naked Call
Let’s assume that an investor sells a call option with a strike price of $50 for a stock currently trading at $45. If the stock remains below $50, the option expires worthless, and the seller keeps the premium collected from the buyer.
However, if the stock price rises to $60, the call seller must buy the stock at market price ($60) and sell it to the option holder for $50. This entails a $10 loss per share minus the premium received.
Remember, because there is no upper limit to how high a stock price can go, the potential loss from a naked call is theoretically unlimited. This lack of a limit to potential losses makes selling naked calls one of the riskiest options strategies available.
Naked Call Options Strategy Risks
The naked call strategy is inherently high-risk due to the unlimited loss potential. Unlike covered calls, where the seller owns the underlying asset, naked call sellers must buy shares at market price if the option is exercised. Here are four general aspects that influence the risk associated with the naked call strategy:
- Unlimited losses: Since stock prices have no upper limit, a sudden rally in the underlying asset can force a naked call option seller to buy costly shares and sell them at a steep discount.
- Margin requirements: Because of the high-risk nature of naked calls, brokers typically require traders to maintain a significant margin balance. The required margin may be a set amount, or a percentage based on the value of the trade. If the stock price moves against the trader, they may face a margin call, forcing them to deposit more funds or close the position at a loss.
- Market volatility: Sudden price swings or unexpected news can lead to rapid price increases. In some cases, it can be difficult to exit a trade before prices rise to the point significant losses become unavoidable.
- Assignment risk: If the stock price rises above the strike price, the option holder may exercise the call. When this happens, the seller must buy shares at the higher market price and sell them at the lower price. In the event of a large price increase, this can result in sizable losses.
Naked Call Options Strategy Pros and Cons
While risky, the naked call strategy can be profitable under the right conditions. Here are two common benefits that could help you decide:
- Premium income: Selling naked calls generates immediate income from the option premium. This can be a quick and consistent source of profit as long as the stock price stays below the strike price.
- Capital efficiency: Unlike covered calls, naked calls do not require the seller to hold shares. Since they don’t have to buy shares, traders are free to allocate their capital elsewhere while still generating income.
And, here are two common drawbacks for you to consider as well:
- Unlimited loss potential: If the stock price rises dramatically, the potential losses can be catastrophic. That’s why risk management is critical when using this strategy.
- Margin and collateral requirements: Most brokers impose strict margin requirements before permitting traders to sell naked calls. These requirements can tie up a significant portion of a trader’s capital.
How to Sell Naked Calls
Because of the high-risk nature of these trades, traders need to meet certain criteria before brokers will approve these trades. Here are four general steps you can take to sell naked calls:
- Get broker approval. Most brokers require Level 4 or 5 options trading approval, which includes financial background checks and experience verification.
- Meet margin requirements. Naked calls require substantial margin reserves to cover potential losses.
- Select a stock and strike price. Traders choose a stock they believe will not rise above the strike price before expiration.
- Monitor the position. Since losses can be large, it is essential to actively monitor the position and be prepared to take action to manage risks, which may include purchasing protection options or placing loss-limit orders.
Bottom Line
The naked call options strategy is a high-risk, high-reward approach that may be used by traders who expect a stock’s price to stay the same or increase a limited amount over a certain time frame. This strategy offers quick premium income, but because of the unlimited loss potential it is essential to practice risk management. It is suitable only for experienced traders who fully understand the risks and mechanics.
Tips for Investment Planning
- A financial advisor can help you identify investment opportunities and manage risk for your portfolio. Finding a financial advisor doesn’t have to be hard. SmartAsset’s free tool matches you with vetted financial advisors who serve your area, and you can have a free introductory call with your advisor matches to decide which one you feel is right for you. If you’re ready to find an advisor who can help you achieve your financial goals, get started now.
- If you want to know how much you could pay in taxes for the sale on an investment, SmartAsset’s capital gains calculator can help you get an estimate.
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