What Is a Naked Call Options Strategy?

A naked call, or uncovered call, is generally considered a high-risk option strategy. Naked calls are when an investor sells or writes call options for an underlying security they don’t own. The seller is anticipating that the underlying stock price will not increase before the call’s expiration date, which may require them to purchase shares that are higher than the market price to close the position.

It is almost always safer for traders to sell calls on a stock they already own — known as a “covered call” position — than those they don’t. This way, if the stock price increases sharply, the trader’s net position is hedged. Naked calls, on the other hand, may be considered speculative trades. You keep the premium if the underlying asset is at or in the money at expiration, but you also face the potential of seeing unlimited losses if the option to buy is exercised.

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 generally much less risky to use a “covered call strategy” and 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 call 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 lower 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 may be achieved when the stock price is below the breakeven price.

Investing in naked calls comes with significant risk and requires discipline and a firm grasp of common options trading strategies.

Writing a Naked Call

Although there are significant risks to naked calls, the process of writing them can be straightforward. 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 remain below the strike price at expiration, the naked call writer will keep the premium (or credit) collected. However, if the company that issued the shares releases unexpected good news, or the shares simply have positive price momentum, the stock price can go upward and expose the naked call writer to potentially significant losses should the buyer exercise the call option.

There are dozens of options on stocks and exchange-traded funds (ETFs) with differing expiration dates and strike prices. For this reason, a trader must take a directional position on the underlying stock price while also accounting for the impact of time decay leading up to expiration. Keeping a close eye on implied volatility is important, too.

Closing Out a Naked Call

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

Naked Call Example

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

For our example, we’ll assume the trader sells a call option at the $110 strike price expiring three months from today. This option comes with a premium of $5 per share, which they receive for selling their options. This call option would be considered “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 theta. At initiation, the trader sells to open the trade, and then collects the $5 premium per share.

As the option nears its expiration date, time value diminishes, and the option price may decrease if the stock price does not significantly rise. If the stock price ends below the strike price by expiration, the option could expire worthless, allowing the trader to retain the full premium as profit.

Conversely, if the stock price increases significantly — say from $50 to $60 — the traders who sold the call at a $52 strike price could face a loss of at least $8 per share ($60 market price minus the $52 strike price, less any premium received). If multiple contracts are sold, the losses can add up quickly.

For example, if the stock price rises during the contract period, the trader who sold the call option may face increasing losses as the stock moves further above the strike price.

Using Naked Calls

In general, naked calls are best suited for experienced traders who have a risk management strategy in place already.

Naked calls may appeal to traders seeking speculative opportunities, since they may profit if the underlying stock price remains stable or declines. The strategy comes with the risk of potentially unlimited losses and other considerations, such as liquidity concerns and the potential need for a margin account or leverage.

The challenge of trading naked calls is the need for sufficient liquidity to manage adverse price movements. If the underlying stock experiences unexpected positive momentum, its price may rise sharply, leading to substantial losses for the trader. This risk is compounded when a trader does not have adequate funds to cover the margin requirements associated with the position.

This strategy may require you to open a margin account with a broker so you can tap into their liquidity if necessary. Brokers typically enforce strict margin requirements for naked calls to mitigate this risk, which can result in margin calls if the account value drops too low.

Naked call strategies are most appropriate for seasoned traders who thoroughly understand options mechanics, as well as the factors that influence price movements (volatility, time decay, and underlying stock performance). These traders should implement stringent risk controls, such as predefined exit strategies and position sizing, to limit exposure.

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:

Naked Call Alternatives

One common alternative to naked calls is known as “covered call writing.” This strategy includes owning the underlying stock while selling calls against it. This can be a more risk-averse alternative to naked calls, but the trader must still have enough cash to purchase the necessary shares (unless they are using margin trading).

There are other, more complex options strategies that can help 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 asset. 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 — however, that loss can be significant.

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.

[product_push_invest_options]

Photo credit: iStock/twinsterphoto

SoFi Invest®