Naked Calls Explained: Strategy, Risks & Rewards

A naked call is a type of option strategy where an investor writes (sells) a call option without the security of owning the underlying stock. The investor must take the short side of the call option in order to deliver shares of the underlying security if the option is exercised before the date of expirationExpiration Date (Derivatives)The expiration date refers to the date in which options or futures contracts expire. It is the last day of the validity of the derivatives contract..

For investors going the speculative options trading route, among the riskiest of investments is a naked call. There are several ways to profit based on how stocks move. OptionsOptions: Calls and PutsAn option is a derivative contract that gives the holder the right, but not the obligation, to buy or sell an asset by a certain date at a specified price. provide a variety of strategies for investment because there are numerous ways to combine both the purchase and sale of call and put options.

Call options contracts enable their owners to buy the options’ underlying securities at a previously specified strike priceStrike PriceThe strike price is the price at which the holder of the option can exercise the option to buy or sell an underlying security, depending on up until the date that the contracts expire.

Summary

• Call options contracts enable their holders to buy the options’ underlying securities at a previously specified strike price up until the date that the contracts expire.
• A naked call is a type of options strategy where investors write a call option without the security of owning the underlying stock.
• Naked calls are, by their nature, not a conservative trading strategy and thus should only be used by experienced traders with a high risk tolerance.

Understanding Naked Calls

The naked call strategy is very risky because, should the option be exercised, the investor is then required to purchase the option’s underlying stock at the current market price. Stock prices, by their nature, come with limitless maximums, meaning that if the option is exercised, the investor stands to lose a significant amount of money.

Example of a Naked Call

Let’s look at an example of a naked call. If a stock is trading at $20, but the investor doesn’t believe the stock will climb higher than $35, he may sell a naked $35 call option. For this example, we’ll say that the premium the investor receives for the option is $100.

An investor uses the naked call strategy with the maximum gain in mind. He believes the stock’s underlying price won’t exceed the amount of the options contract and thus won’t be exercised. If the option isn’t exercised, the investor keeps the entire premium, which, in this example, would be $100.

Again, naked calls are extremely risky because of the potential for loss. For the example above, let’s say that the option’s underlying stock climbs to $50, and the option holder exercises the option. It means that the investor must go out and buy 100 shares of the stock at $50, shares that he’s already effectively sold for $35 a share.

So, for each share, the investor loses $15. $15 times 100 shares = $1,500. Minus the $100 premium he received for selling the option, the investor’s net loss is a whopping $1,400.

Ultimately, every investor’s goal is to make money on their investments. Naked calls are, by their nature, not a conservative trading strategy and thus should be used by experienced traders.

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