Financial Topics Archives | Page 751 of 800

Feb

2022

What Does At the Money Mean in Options Trading?

By Dan Miller | Growing Wealth, invest, Investing | Comments Off

An at-the-money (ATM) option is one where the strike price is at or very near the current price of the underlying stock itself. At the money options have no intrinsic value.

Options traders must understand the difference between the three types of options “moneyness: “at the money,” “in the money,” and “out-of-the money.”

What Is At the Money?

At the money means that a given option’s strike price is identical to the price of the underlying stock itself. Both a call option and a put option can be at the money at the same time, if their strike price is the same as the price of the stock.

In this age of decimal stock pricing, it is rare for an option’s strike price to exactly equal the price of the underlying stock — so the at-the-money strike is usually considered the one closest to the stock’s price.

Understanding At the Money

Usually, an option that is at the money will have a delta of around 0.50 for an at the money call option and -0.50 for a put option. This means that for every $1 of movement of the underlying stock, the option will move about 50 cents.

Some options traders employ more complicated strategies, such as an at the money straddle, which involves buying or selling both an at-the-money call and an at-the-money put with the same expiration date.

At the Money vs In the Money vs Out of the Money

Usually there is one option strike price considered at the money, with any other strike prices being either in the money (ITM) or out of the money (OTM). The difference between ITM and OTM is that an in-the-money option is one that has intrinsic value, meaning it would be profitable to exercise it today.

For calls, being in the money means a strike price lower than the stock’s price. For put options, a strike price that is higher than the stock’s price is considered in the money.

Out-of-the money options are just the opposite. They have no intrinsic value, and if an option is out of the money at expiration it will expire worthless.

Consider the following call or put options for stock ABC with a current price of 55.

Option	Strike price	ATM / ITM / OTM
ABC Call option	55	At the money
ABC Put option	55	At the money
ABC Call option	70	Out of the money
ABC Put option	70	In the money
ABC Call option	40	In the money
ABC Put option	40	Out of the money

Recommended: Call vs. Put Options: The Differences

At the Money and Near the Money

An option is considered near the money usually if it is within 50 cents of the price of the underlying stock. However, it is common for investors to use the terms “near the money” and “at the money” interchangeably.

This is because stocks are priced to the nearest cent, while option strike prices are usually only to the nearest dollar or half-dollar, depending on the magnitude of the underlying stock price. So it is rare for a stock to have an option that exactly matches any specific strike price.

Pricing At-the-Money Options

Because an at-the-money option has a strike price exactly the same as the price of the underlying stock, it has no intrinsic value. Any value in an ATM option is made up of extrinsic value or time value. While you could make more money with an option than just by purchasing the stock if the stock moves in the direction you anticipate, you also stand to completely lose your investment if the stock moves against you.

At the Money and Volatility Smile

The volatility smile refers to the phenomenon that implied volatility is generally lower for at-the-money options than it is for options that are in the money or out of the money. The term “volatility smile” reflects a graph of implied volatility against the strike price of an option, which appears as an upwards-opening parabola, similar to a smile.

Pros and Cons of Trading At-the-Money Options

Here are some pros and cons of trading at-the-money options:

Pros of trading at-the-money options	Cons of trading at-the-money options
Less-expensive than at-the-money options	More expensive than out-of-the-money options
Can protect you from downside risk on stocks you already own	ATM options have no intrinsic value and may expire worthless
	If the stock moves in a different direction than you anticipate, you could lose your entire investment

The Takeaway

Understanding the difference between options that are at the money (ATM), in the money (ITM) and out of the money (OTM) is crucial if you want to trade options through your brokerage account. Prices with these three different types of options contracts react differently to movements in the price of the underlying stock, so make sure you buy the right one based on your overall strategy.

An options trading platform that provides educational resources about options can be a good way to continue learning as you go. SoFi offers this alongside its user-friendly options trading platform, where investors can trade options from the mobile app or web platform.

Trade options with low fees through SoFi.

FAQ

What does buying at the money mean?

When you buy an at-the-money option, you are buying an option whose strike price is at or near the price of the underlying stock. An option that is at the money generally has a delta value of around positive or negative 0.50, depending on if it is a call or a put. That means its price will move about 50 cents for every dollar that the price of the underlying stock moves.

How do at the money and in the money differ?

An at-the-money option is one whose strike price is at or near the price of the underlying stock. An in-the-money option is one with a strike price that would be exercised if the option closed today. An at-the-money call option is one whose strike is lower than the stock price, while an at-the-money put option is one whose strike price is higher than the stock price.

Is it best to buy at the money?

There are several different strategies for trading options, and the strategy you trade will help decide whether it’s a good idea to buy at the money. It can certainly be profitable to buy or sell at-the-money options, but other strategies for making money with options exist as well.

Photo credit: iStock/DMEPhotography

SoFi Invest®

INVESTMENTS ARE NOT FDIC INSURED • ARE NOT BANK GUARANTEED • MAY LOSE VALUE

SoFi Invest encompasses two distinct companies, with various products and services offered to investors as described below: Individual customer accounts may be subject to the terms applicable to one or more of these platforms.
1) Automated Investing and advisory services are provided by SoFi Wealth LLC, an SEC-registered investment adviser (“SoFi Wealth“). Brokerage services are provided to SoFi Wealth LLC by SoFi Securities LLC.
2) Active Investing and brokerage services are provided by SoFi Securities LLC, Member FINRA (www.finra.org)/SIPC(www.sipc.org). Clearing and custody of all securities are provided by APEX Clearing Corporation.
For additional disclosures related to the SoFi Invest platforms described above please visit SoFi.com/legal.
Neither the Investment Advisor Representatives of SoFi Wealth, nor the Registered Representatives of SoFi Securities are compensated for the sale of any product or service sold through any SoFi Invest platform.

Options involve risks, including substantial risk of loss and the possibility an investor may lose the entire amount invested in a short period of time. Before an investor begins trading options they should familiarize themselves with the Characteristics and Risks of Standardized Options . Tax considerations with options transactions are unique, investors should consult with their tax advisor to understand the impact to their taxes.
SOIN0122051

Feb

2022

A Guide to Collars in Options Trading

By Mike Zaccardi, CMT, CFA | Growing Wealth, invest, Investing | Comments Off

A collar is an options strategy used by traders to protect themselves against heavy losses. The strategy, also known as a hedge wrapper, involves taking a long position in an underlying stock, buying an out-of-the-money put, and selling an out-of-the-money call.

Essentially with an option collar, you’re buying a protective put and a covered call at the same time on a stock that you already own or have long exposure to. While collars in options protect against heavy losses, they also limit potential gains. Read on to learn more about collar breakeven points, max loss, and max profit.

What Is a Collar Option?

In collar options strategies, an options trader limits the range of their returns by taking a long position in the underlying stock, buying a lower strike put, and selling a higher strike call. Typically, the stock price will be between the two strike prices. A trader uses a collar when they are bullish on the underlying stock but want to be protected against the risk of large losses.

A collar is also a useful option strategy when the goal is to protect unrealized gains on the stock.

How Do Collars Work?

A collar works by protecting a trader’s existing long stock position by buying a put option, limiting any further losses should the stock price fall below the strike of the put. At the same time, the sale of an out-of-the-money call helps finance the trade, making the cost of protection cheaper than purchasing a put on the underlying shares, with the trade-off that gains will be capped should the stock rise above the strike of the call. The trader constructs a collar through their brokerage when they think there could be near-term weakness in the stock but do not want to sell their stock position.

Buying a put gives the trader the right, but not the obligation, to sell the stock at the put’s strike price. Selling the call obligates the writer to sell the stock at the call’s strike if the option is assigned. Meanwhile, the trader remains long shares of the underlying stock.

Maximum Profit

The short call position in a collar option strategy caps upside, limiting the maximum potential profit. The max profit depends on if the investor established the options trade at a net debit or a net credit.

• Net debit: Maximum profit = Call strike price – stock price – net debit, or

• Net credit: Maximum profit = Call strike price – stock price + net credit = max profit

At a high level, the trader makes the most money when the stock price is at or above the call’s strike at expiration.

Maximum Loss

The protective put limits losses in the event the underlying share price falls below the put’s strike. So either

• Net debit: Maximum loss = Stock price – put strike price – net debit paid, or

• Net credit: Maximum loss = Stock price – put strike price + net credit received

Breakeven Points

Once established, a collar option has two possible break even points – again, dependent on whether the trade was executed at a net credit or debit.

• Net debit: Break even point = current stock price + net debit, or

• Net credit: Break even point = current stock price – net credit

Impact of Price Changes

A collar keeps a trader’s long-term bullish stance but it protects unrealized profits from a short-term share price decline. If the underlying stock price rises, the collar provides some exposure to upside gains, capped at the short call’s strike. The real value of a collar comes if the stock price drops through the long put strike. The collar protects the trader from further losses.

Another way to look at the impact of price changes is to view it from a perspective of time – a collar can help a trader with a short-term bearish outlook but a bullish long term view. Collars have a positive Delta.

Impact of Volatility Changes

Changes in volatility have a relatively smaller impact on a collar options strategy versus other options trades because the trader has simultaneous long and short option positions. The collar trade usually has a near-zero vega.

Recommended: What Are the Greeks in Options Trading?

Impact of Time

With a collar options trade, the effect of time decay depends on how close the stock price is to the option strike prices.

Time decay works to the trader’s benefit when the underlying stock price rallies up to the short call’s strike. On the flip side, the impact of time hinders the trade when the stock price nears the long put’s strike. When the stock price is about equally between the two strikes, time decay is neutral since both option prices erode at approximately the same rate. So, while the short put value drops, the long call offsets those gains from time decay.

Pros and Cons of Collars

Pros	Cons
Limits losses from a falling share price	Limits gains from a rising share price
Allows for some upside exposure	Exposes the trader to some risk of loss
Cheaper than only buying puts	Can be a complicated strategy for new traders
Ownership of the stock retained

Collar Option Examples

Here’s a collar option example that will help put these concepts into context: Suppose a trader is long shares of XYZ stock that currently trades at $100. The trader worries about limits to near-term upside and wants to protect against a material share price decline. A collar strategy is a good trade to address these beliefs.

The trader sells a covered call at the $110 strike, receives a $5 premium, and buys a protective put at the $90 strike at a cost of $4. The net credit is $1 and the trader has not paid any commissions. With these two options trades, the trader has capped their upside at the call’s strike and the downside at the put’s strike. The breakeven point is $99 (the current stock price minus the net credit).

Let’s say the stock rallies to the call’s strike by expiration. In this case, the trader makes $10 on the long stock position, keeps the $5 call premium, and lets the put expire worthless. The gain is $11 (the stock price gain plus the options’ net credit received).

If the stock price drops to $80, the trader loses $20 on the stock position, keeps the $5 call premium, and makes $6 on the $90 strike long put. Thus, the net loss is just $9. The trader benefitted from the collar as opposed to just owning the stock which was down $20. The payoff diagram below shows how losses are limited in our trade scenario, but gains are also capped at the $110 mark.

Collar Payoff Diagram

Reasons to Consider Using a Collar Option Strategy

A collar is an effective strategy when an investor expects a stock to trade sideways or down over a period. A trader might also use it when they expect a stock to go up over time and do not want to sell their shares, but they do want to protect unrealized gains – perhaps for tax reasons. A collar option trade is less bearish than buying puts outright, but it protects a trader from large losses. Also, selling the upside call helps finance the protective position.

Limiting Risk

A collar option strategy limits risk beyond the protective put’s strike. Even if a stock price goes to zero, the trader’s loss maxes out at the protective put’s strike.

Protecting an Asset

Another way to protect your stock position is to implement a protective put. With a protective put, a trader buys a put in addition to their long position in the underlying stock. This trade would be more expensive than a collar, since there is no sale of a call option to offset the cost of buying the put, but retains the unlimited upside of the underlying stock position.

The Takeaway

A collar is a strategy whereby a trader protects an unrealized gain on a stock at a reduced cost while still allowing some upside equity participation. Traders might use this strategy for tax purposes, or to limit the overall risk in their portfolio.

While SoFi does not currently offer options traders, it does help investors learn more about options. Investors can also get started by opening a brokerage account on the SoFi Invest investment platform where you can build a portfolio of stocks and exchange-traded funds.

FAQ

What is the maximum profit on a collar option?

The maximum profit on a collar is when the stock price rallies up to the call’s strike price. Above that level, gains are constant since the long stock position is offset by the short call.

Maximum profit = (call option strike price – net of option premiums) – stock purchase price

What is maximum loss on a collar option?

The maximum loss on a collar option trade is when the stock price declines to the put’s strike price. Below that level, losses are limited since the long stock position is offset by the long put.

Maximum Loss = stock purchase price – (put option strike price – net of option premiums)

What is breakeven on a collar option?

The breakeven on a collar strategy at expiration is the current stock price minus the net credit received or the current stock price plus the net debit paid.

Breakeven = stock price + put option premium paid – call option premium received

Photo credit: iStock/gorodenkoff

SoFi Invest®

INVESTMENTS ARE NOT FDIC INSURED • ARE NOT BANK GUARANTEED • MAY LOSE VALUE

Feb

2022

What Are Calendar Spreads and How Do They Work?

By Mike Zaccardi, CMT, CFA | Growing Wealth, invest, Investing | Comments Off

Many options spread strategies consist of buying and selling call or put options that expire at the same time. Calendar spreads, on the other hand, are created by selling a short-dated option and buying a longer-maturity option with the same strike price. Rather than seeking favorable directional movement in the underlying stock, the calendar spread takes advantage of implied volatility and the way that it typically changes over time.

Like other option spread strategies, a calendar spread limits a trader’s potential losses, but it also caps their potential return. Calendar spreads are considered an advanced option trading strategy, so it’s important to have a handle on how they work and the potential risks. Read on to learn more about how to build calendar spreads and when to use them.

Calendar Spreads Defined

A calendar spread, also known as a horizontal spread, is created with a simultaneous long and short position in options on the same underlying asset and strike price but different expiration dates. Calendar spreads can be constructed using calls or puts. The longer-dated option is purchased and the shorter-dated option is sold. Typically, the option that is sold has a near-term expiration date.

How Calendar Spreads Work

Calendar spreads are typically established for a net debit, meaning you pay at the outset of the trade. This is because generally speaking, a longer-dated option will be more expensive than a shorter-dated one if the strike prices are the same.

Time decay is essential to how calendar spreads work. It tends to accelerate as an option’s expiration approaches, which means that all else equal, the short-dated option will lose more value due to time decay than the long-dated option over a given passage of time. If the stock price is at or near the strike price of the options at the time of the first expiration date, the trade should be profitable.

Calendar spreads function fairly similarly whether constructed with calls or puts. Depending on where the stock price is relative to the strike price selected at the outset of the trade, and whether calls or puts are used, a calendar spread can be neutral, slightly bearish, or slightly bullish.

Maximum Profit on Calendar Spread

A calendar spread strategy hits max profit when the stock price settles at the near-term strike price by that option’s expiration. That is not the end of the trade, however. The trader benefits when the stock price rises after the near-dated option’s expiration since they are long the later-date call option.

A rise in implied volatility after the front-month call expires also benefits the later-dated long options position. However, some traders might choose to close the later-dated option position when the near-dated option expires.

Maximum Loss on Calendar Spread

A calendar spread is considered a debit spread since the cost of the later-dated option is greater than the proceeds from the near-date option’s sale. So the trader can not lose more than the premium paid.

Breakeven

The precise breakeven calculation on a calendar spread option trade cannot be determined due to the two different option delivery dates. Traders must estimate what the value of the long-dated option contract will be on the near-dated option’s expiry.

One way to this is using online option strategy profit and loss calculator to estimate a breakeven price. Changing option Greeks – such as implied volatility levels and market interest rates – also make deriving a breakeven price difficult to pin down on this strategy.

Calendar Spread Example

An example helps to understand how calendar spread options work. Suppose XYZ stock is $100, and the trader believes the stock price will not change much in the next month. Based on that neutral thesis, the trader sells a $100 call option expiring in one month for $10 and buys a call at the same $100 strike price that expires in two months at a price of $15. The net debit is $5. The later-dated call option is more expensive because it has more time value than the near-dated call.

Over the next month, the stock fluctuates since the trade was executed, but settles back to $100 on the afternoon of the front-month’s option delivery date. Since time has passed and the stock has not drifted from $100, the near-dated call option has lost considerable time value. The short call expires worthless. The later-dated call is now worth $10.

The trade worked well. The trader exits the position by allowing the near-term call to expire worthless and selling to close the $10 later-dated long call. In essence, the trader made $10 on the short call and lost $5 on the long call for a profit of $5.

Calendar Spread Payoff Diagram

Source: https://www.warriortrading.com/calendar-spread-definition-day-trading-terminology/

Calendar Spread Risks

There are several risks that traders must keep in mind when using calendar spreads.

Limited Upside

This is the main risk in calendar spread strategies, if the trade closes at the near-dated option’s expiry. The options trader benefits from time decay and increases in implied volatility. Once the short option expires or is bought to close, there is unlimited upside potential with the remaining long call. If the trader uses puts they have a significant upside if the stock price goes to zero.

Delivery Dates

Trader must make a choice when the near-dated option is on the precipice of expiring. The trader can let it expire if it is out of the money, but if it is in the money, then it might be worthwhile to buy to close the option.

Timing the Trade

Being correct about the near-term direction of the stock, as well as changes in implied volatility and time decay, can be challenging.

Types of Calendar Spreads

There are several types of calendar spreads. Here’s a look at some of the most popular strategies.

Put Calendar Spread

A calendar put spread option is a strategy in which a trader sells a near-dated put and buys a longer-dated put. A trader would put this trade on when they are neutral to bullish on the price change of the underlying stock in the near-term. Once again, this type of calendar spread options strategy aims to benefit from time decay or higher implied volatility.

Calendar Call Spread

A calendar call spread involves shorting a near-term call and buying a longer-dated call at the same strike. (This is the strategy outlined in the earlier example.) The near-term outlook on the underlying stock is neutral to slightly bearish while the trader might have a longer-term bullish view.

Diagonal Calendar Spread

A diagonal calendar spread uses different strike prices for the two options positions. This strategy still uses two options – either two calls or two puts – with different expiration dates. This strategy can be either bullish or bearish depending on how the trade is constructed. The term diagonal spread simply refers to the use of both a calendar spread (horizontal) and a vertical spread.

Short Calendar Spread

Traders can use a short calendar spread with either calls or puts. It is considered a “short” calendar spread options strategy because the trader buys the near-dated option while selling the longer-dated option. This is the opposite of a long calendar spread. A short calendar spread profits from a large move in the underlying stock.

Trading Stocks with SoFi

Calendar spreads are useful for traders who want to profit from changes in stock variables other than price direction. They’re an advanced strategy, however, that may not make sense for beginner investors.

However, you do not need to use any options at all to build a portfolio that helps you meet your goals. SoFi does not currently offer options, but it does provide an easy way to start building a portfolio. By opening an online brokerage account on the SoFi Invest® investment app, you can start trading in individual equities, fractional shares, and exchange-traded funds (ETFs) directly from your phone.

Photo credit: iStock/Tatomm

SoFi Invest®

INVESTMENTS ARE NOT FDIC INSURED • ARE NOT BANK GUARANTEED • MAY LOSE VALUE

Feb

2022

SPAN Margin: How It Works, Pros & Cons

By Mike Zaccardi, CMT, CFA | Growing Wealth, invest, Investing, Terminology | Comments Off

Options trading is far more complex than trading stocks and exchange-traded funds (ETFs). Trading and valuing options includes many variables including intrinsic value and time value, implied volatility, and weighing changes in interest rates.

The SPAN system determines margin requirements on options accounts by considering many inputs along with a portfolio’s global (total) assets to conduct a one-day risk assessment. This article will dive deep into how SPAN works and what investors need to know about it.

What Does SPAN Stand For?

SPAN stands for standardized portfolio analysis of risk, and is an algorithm used in options and futures margin trading.

What Is SPAN Margin?

The SPAN margin calculation helps options traders understand risk in their accounts and assists brokers in managing risk. SPAN is used by options and futures exchanges around the world to determine a trader’s one-day worst-case scenario based on their portfolio positions. Margin requirements can be set in an automated way from the calculation’s output.

Unlike the margin in a stock trading account, which is essentially just a loan from a broker, the margin in an options or futures account is considered a good-faith deposit or a performance bond. It is helpful to understand how a margin account functions before trading complex strategies.

How Does SPAN Margin Work?

The SPAN margin calculation uses modeled risk scenarios to determine margin requirements on options and futures. The primary variables included in the algorithm are strike prices, risk-free interest rates, price changes in the underlying assets, volatility shifts, and the effect of time decay on options.

While buying options typically does not require margin, writing (or shorting) options requires a deposit. In essence, the options seller exposes the broker to risk when they trade. To reduce the risk that the trader cannot pay back the lender, margin requirements establish minimum deposits that must be kept with the broker.

Rather than using arbitrary figures, the SPAN system automates the margin setting process, using algorithms and many sophisticated inputs to determine margin requirements. SPAN margin looks at the worst-case scenario in terms of one-day risk, so the margin requirement output will change each day.

The analysis is done from the portfolio perspective since all assets are considered. For example, the SPAN margin calculation can take excess margin from one position and apply it to another.

SPAN margin also imposes requirements on options and futures contract sellers, known as writers. Traders who are short derivatives contracts often expose the lender to greater risk since losses can be unlimited depending on the positions taken. The broker wants to ensure their risk is protected if the market turns against options and futures writers.

Pros and Cons of SPAN Margin

There are upsides and downsides to SPAN margin in options and futures trading.

The Advantages

Futures options exchanges that use the SPAN margin calculation allow Treasury Bills to be margined. Though fees are typically also imposed by many clearinghouses, the interest earned on the Treasurys may help offset transaction costs if interest rates are high enough.

There is another upside: Net option sellers benefit from SPAN’s holistic portfolio approach. SPAN combines options positions when assessing risk. If you have an options position with a substantial risk in isolation but another options position that offsets that risk, SPAN considers both. The effect is a potentially lower margin requirement.

The Downsides

While SPAN is savvy enough to look at both pieces of an option seller’s combination trade, there are never perfect hedges. Many variables are at play in derivatives markets. There can still be strict margin levels required based on SPAN margin’s one-day risk assessment.

Summary

Pros	Cons
Determines margin requirements from an overall portfolio perspective	There still might be high margin requirements when two positions do not offset
Traders know their margin amount each day based on the latest market variables	Changing market conditions can mean big shifts in day-to-day SPAN margin amounts
Margin deposits in options or futures accounts can collect interest

SPAN and Exposure Margin

Exposure margin is the margin blocked over and above the SPAN margin amount to protect against any mark-to-market losses. Like SPAN margin, exposure margin is set by an exchange. The exchange will block off your entire initial margin (both SPAN margin and exposure margin) when you initiate a futures transaction.

The Takeaway

SPAN margin is helpful to manage risks in trading markets. Algorithms determine margin requirements based on a one-day risk analysis of a trader’s account. While primarily used in futures trading and when writing options, investors should know about this critical tool in financial markets.

Margin accounts come with a unique set of risks and rewards. You can learn more about margin trading with SoFi’s resources.

You can also explore investing options on the SoFi Invest® app. It allows members to research investment opportunities based on their individual risk and return objectives.

Find out how to get started at SoFi Invest.

FAQ

What does SPAN stand for in margin trading?
SPAN margin stands for “standardized portfolio analysis of risk.” It is a system used by many options and futures exchanges worldwide.

How is SPAN margin used?

SPAN margin is used to manage risk in trading markets. It calculates the suggested amount of good-faith deposit a trader must add to their account in order to engage in options or futures trading. To help mitigate the risk that traders will not be able to pay back the funds the broker lends them, exchanges use the SPAN system to calculate a worst possible one-day outcome and set a margin requirement accordingly. SPAN margin reduces the risk of a trader growing their leverage ratio too high based on the automated risk calculations. SPAN margin can also allow lower margin requirements for options sellers who trade multiple positions.

What is a SPAN calculation?

SPAN is calculated using risk assessments. That means an array of possible outcomes is analyzed based on different market conditions using the assets in a portfolio. These risk scenarios specify certain changes in variables such as price changes, volatility shifts, and decreasing time to expiration in options trading.

Inputs into a SPAN calculation include strike prices, risk-free interest rates, price changes in underlying assets, implied volatility changes, and time decay. After calculating the margin on each position, SPAN can shift excess margin on a single position to other positions that might be short on margin. It is a sophisticated tool that considers a trader’s entire portfolio.

Photo credit: iStock/NakoPhotography

SoFi Invest®

INVESTMENTS ARE NOT FDIC INSURED • ARE NOT BANK GUARANTEED • MAY LOSE VALUE

SoFi Invest encompasses two distinct companies, with various products and services offered to investors as described below: Individual customer accounts may be subject to the terms applicable to one or more of these platforms.
1) Automated Investing and advisory services are provided by SoFi Wealth LLC, an SEC-registered investment adviser (“SoFi Wealth“). Brokerage services are provided to SoFi Wealth LLC by SoFi Securities LLC.
2) Active Investing and brokerage services are provided by SoFi Securities LLC, Member FINRA (www.finra.org)/SIPC(www.sipc.org). Clearing and custody of all securities are provided by APEX Clearing Corporation.
For additional disclosures related to the SoFi Invest platforms described above please visit SoFi.com/legal.
Neither the Investment Advisor Representatives of SoFi Wealth, nor the Registered Representatives of SoFi Securities are compensated for the sale of any product or service sold through any SoFi Invest platform.

Financial Tips & Strategies: The tips provided on this website are of a general nature and do not take into account your specific objectives, financial situation, and needs. You should always consider their appropriateness given your own circumstances.

*Borrow at 11%. Utilizing a margin loan is generally considered more appropriate for experienced investors as there are additional costs and risks associated. It is possible to lose more than your initial investment when using margin. Please see SoFi.com/wealth/assets/documents/brokerage-margin-disclosure-statement.pdf for detailed disclosure information.
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Feb

2022

What Is a Naked Call Options Strategy?

By Mike Zaccardi, CMT, CFA | Growing Wealth, invest, Investing | Comments Off

A naked call, or uncovered call, is an aggressive, high-risk option strategy. It occurs when an investor sells or writes call options for which they don’t own the underlying security. The seller is betting that the underlying stock price will not increase before the call’s expiration date.

It is safer for traders to sell calls on a stock they already own. This way, if the stock price increases sharply, the trader’s net position is hedged. A hedged position, in this example, means that as the stock value rises, the long-stock position grows while the short-call option position loses. This situation describes a “covered call” position, which is a much lower risk strategy.

Naked calls, on the other hand, are speculative trades. You keep the premium if the underlying asset is at or in the money at expiration, but you also have the potential for unlimited losses. Read on for more about what naked calls are, how they work, their risks and rewards, and more.

Understanding Naked Calls

When a trader sells or writes a call option, they are selling someone else the right to purchase shares in the underlying asset at the strike price. In exchange, they receive the option premium. While this immediately creates income for the option seller, it also opens them up to the risk that they will need to deliver shares in the underlying stock, should the option buyer decide to exercise.

For this reason, it is significantly less risky to use a “covered call strategy” or sell an option on an underlying asset that you own. In the case of stocks, a single option generally represents 100 shares, so the trader would want to own 100 shares for each option sold.

Trading naked calls, on the other hand, is among the more speculative options strategies. The term “naked” refers to a trade in which the option writer does not own the underlying asset. This is a neutral to bearish strategy in that the seller is betting the underlying stock price will not materially increase before the call option’s expiration date.

In both the naked and the covered scenarios, the option seller gets to collect the premium as income. However, selling a naked call requires a much lower capital commitment, since the seller is not also buying or owning the corresponding number of shares in the underlying stock. While this increases the potential return profile of the strategy, it opens the seller up to potentially unlimited losses on the downside.

How Do Naked Calls Work?

The maximum profit potential on a naked is equal to the premium for the option, but potential losses are limitless. In a scenario where the stock price has gone well above the strike price, and the buyer of the option chooses to exercise, the seller would need to purchase shares at the market price and sell them at the strike price. Hypothetically, a stock price has no upper limit, so these losses could become great. When writing a naked call, the “breakeven price” is the strike price plus the premium collected; a profit is made when the stock price is below the breakeven price.

Investing in naked calls requires discipline and a firm grasp on common options trading strategies.

Writing a Naked Call

While there are significant risks, the process of naked call writing is relatively easy. An individual enters an order to trade a call option, but instead of buying they enter a sell-to-open order. Once sold, the trader hopes the underlying stock moves sideways or declines in value.

So long as the shares do not rise quickly, and ultimately remain below the strike price at expiration, the naked call writer will keep the premium collected (also known as the credit). Unexpected good news or simply positive price momentum can send the stock price upward, leading to higher call option values.

On the most common stocks and exchange-traded funds (ETFs), there are dozens of option strike prices at various expiration dates. For this reason, a trader must make both a directional bet on the underlying stock price and a time-wager based on the expiration date. Keeping a close eye on implied volatility is important, too.

Closing Out a Naked Call

When the trader wants to exit the trade, they punch in a buy-to-close order on the short calls. Alternatively, a trader can buy shares of the underlying asset to offset the short call position.

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Naked Call Example

Let’s say a trader wants to sell a naked call option on shares of XYZ. Let’s also assume the stock trades at $100 per share.

For our example, we will assume the trader sells a call option at the $110 strike price expiring three months from today. This option might have a premium, or cost, of $5. The call option is said to be “out of the money” since the strike price is above the underlying stock’s current price.

Thus, the option only has extrinsic value (also known as time value). This naked call example seeks to benefit from the option’s time decay, also known as its theta. At initiation, the trader sells to open, then collects the $5 premium per share.

The trade’s breakeven price is $115 ($110 strike price plus $5 premium). Jump ahead a month, and shares of XYZ have rallied to $110. The value of the $110 strike call option, now expiring in just 60 days, is worth $9 since the share price rose $10.

On the other hand, the option’s time value dropped modestly since the expiration date drew closer. After pocketing the $5 premium at the trade’s initiation, the trader effectively owes $9 back, resulting in a net loss on paper.

Fast-forward to the week of expiration: XYZ’s stock price has fallen to $100. The $110 call option with just a few days left until expiration – Friday, is worth just $0.50 of time value with no intrinsic value. The trader chooses to close the trade with a buy-to-close order to lock in that $0.50 price.

In summary, the trader collected the $5 premium at the onset of the trade, experienced paper losses when XYZ’s stock price rose, but then ended on the winning side of the ledger by expiration when the position closed. The traders realized a profit of $4.50 considering the $5 sell and $0.50 buy-back. The trader could have also allowed the option to potentially expire worthless, which could have netted a $5 profit.

Using Naked Calls

Trading naked calls sometimes appeals to new traders who do not fully grasp risk and return probabilities. The notion that you can make money simply if a stock price or ETF does not go up in value sounds great. The problem arises when the underlying security appreciates quickly.

A naked call writer might not have enough cash to close the position. For this reason, brokers often have margin requirements on traders seeking to sell naked calls. When an account’s margin depletes too far, the broker can issue a margin call requiring the trader to deposit more cash or assets.

In general, naked calls make the most sense for experienced traders who have a risk management strategy in place before engaging in this type of trade.

Risks and Rewards

The potential for unlimited losses makes naked call writing a risky strategy. The reward is straightforward — keeping the premium received at the onset of the trade. Here are the pros and cons of naked call option trading:

Pros	Cons
Potential profits from a flat or declining stock price	Unlimited loss potential
Allows theta to work in your favor	Reward limited to the premium collected
Generates income	Margin calls when the underlying appreciates

Naked Call Alternatives

A common alternative to selling a naked call is to simply own the stock then sell calls against that position. This technique is known as “covered call writing”. This is a safer alternative to risky naked calls, but the trader must have enough cash to purchase the necessary shares.

One options contract covers 100 shares, so purchasing 100 shares of XYZ at $100 per share requires $10,000 of capital, unless the investor makes use of margin trading.

Other complex options strategies can achieve results similar to naked call writing. Covered puts, covered calls, and bear call spreads are common alternatives to naked calls. Experienced options traders have strategies to manage their risk, but even sophisticated traders can become overconfident and make mistakes.

Selling naked puts is another alternative that takes a neutral to bullish outlook on the underlying. When selling naked puts, the trader’s loss potential is limited to the strike price (minus the premium collected) since the stock can only go to $0.

The Takeaway

A naked call strategy is a high-risk technique in which a trader seeks to profit from a declining or flat stock price. The maximum gain is the premium received while the risk is unlimited potential losses. As with all option trading strategies, traders need to understand the risks and benefits of selling naked calls.

To make informed options trading decisions, it can help to have a platform that offers educational resources you can reference along the way. SoFi’s options trading platform offers a library of such resources, as well as an intuitive and approachable design. Plus, investors have the choice of trading options either on the mobile app or the web platform.

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