Selling Naked Calls (Unsecured Calls)
Selling naked calls is a popular options trading strategy that involves selling call options without owning the underlying stock. While it can be a profitable strategy, it is also considered high-risk and is only recommended for experienced traders.
In this article, we will explore the ins and outs of selling naked calls, including what they are, how they work, and the potential risks and rewards. Whether you are a seasoned options trader or just starting out, understanding the intricacies of this strategy can help you make informed trading decisions and maximize your profits.
What Is a Naked Call?
A naked call, also known as an uncovered call, is an options trading strategy where the seller of the call option does not own the underlying asset. The seller, also known as the writer, is therefore exposed to unlimited potential losses if the price of the underlying asset rises significantly.
In a naked call strategy, the seller collects a premium from the buyer of the call option in exchange for the right to purchase the underlying asset at a specific price (strike price) before the expiration date of the option. If the price of the underlying asset stays below the strike price, the seller keeps the premium and the option expires worthless.
However, if the price of the underlying asset rises above the strike price, the seller is obligated to sell the asset to the buyer at the lower strike price. This means the seller will have to buy the asset at the market price and sell it to the buyer at the lower strike price, resulting in a significant loss.
Naked calls are considered a high-risk strategy because of the unlimited potential losses involved, and are typically used by experienced traders who are willing to take on significant risk in exchange for potentially high returns.
Selling Naked Calls vs. Selling Covered Calls
Selling covered calls is a strategy in which the seller sells call options on a stock they already own. If the option is exercised, the seller can easily deliver the shares they already possess. This approach is generally perceived as less risky compared to selling naked calls because the seller of covered calls can precisely calculate the risk based on the amount they paid for the shares. On the other hand, with naked calls, the seller must purchase the shares regardless of the market price and sell them at the lower strike price.
Selling Naked Calls Example
Let’s say you believe that the price of XYZ stock, currently trading at $50 per share, is going to stay relatively stable or decrease in the near future. You decide to sell a naked call option on XYZ stock with a strike price of $55 and an expiration date of one month from now. You collect a premium of $2 per share from the buyer of the option.
If the price of XYZ stock stays below the strike price of $55 per share until the option’s expiration date, the option will expire worthless, and you will keep the $2 per share premium as profit. However, if the price of XYZ stock rises above $55 per share, the buyer of the option may exercise their right to buy the shares from you at the lower strike price of $55 per share.
In that case, you would have to buy the shares at the market price, which could be significantly higher, and sell them to the buyer at the lower strike price, resulting in a potential loss. For example, if the price of XYZ stock rises to $60 per share, you would have to buy the shares at $60 and sell them at $55, resulting in a $5 per share loss, which could add up quickly if you sold many naked call options.
How to Sell Naked Calls
Selling naked calls involves selling call options on a security without owning the underlying asset. Here are the general steps involved in selling naked calls:
- Choose a security: Identify security that you believe will remain stable or decrease in price in the near future. This could be a stock, index, or ETF.
- Determine a strike price and expiration date: Select a strike price that is higher than the current market price of the security and an expiration date that gives the stock time to stay below the strike price. These factors will determine the premium you will receive for selling the option.
- Sell the call option: Sell the call option to a buyer through a broker. The buyer of the call option will pay you a premium for the right to buy the underlying security at the strike price before the expiration date.
- Wait for expiration or take action: If the price of the underlying security stays below the strike price until the option expires, the option will expire worthless and you will keep the premium as profit. However, if the price rises above the strike price, the buyer may exercise their option and you will have to deliver the underlying asset at the lower strike price. At this point, you may choose to buy the underlying asset at the market price and sell it to the buyer at the lower strike price, or you may buy back the option to close out the position.
Selling naked calls can be a useful strategy for generating income from premiums, but it does require careful monitoring and management.
How to Adjust Naked Calls
When selling naked calls, it’s important to have a plan for adjusting your position if the price of the underlying asset rises significantly above the strike price. Here are some potential ways to adjust naked calls:
- Buy back the call option: If the price of the underlying asset rises and the option is now in the money, you can buy back the call option to close out the position and limit your potential losses.
- Roll the option: Rolling an option involves closing out the current position and simultaneously opening a new position with a different strike price or expiration date. Rolling a naked call can allow you to move the strike price higher or extend the expiration date, which can help reduce your potential losses. However, rolling a position also involves additional costs and risks.
- Sell a put option: Selling a put option on the same underlying asset can help offset the potential losses from a naked call position. If the price of the underlying asset falls and the put option is in the money, you can collect the premium from the put option and use it to cover the losses from the naked call.
- Implement a stop-loss order: A stop-loss order is an order to buy back the call option if the price of the underlying asset rises above a certain level. This can help limit your potential losses by automatically closing out the position if the market moves against you.
It’s important to note that adjusting a naked call position involves additional risks and costs, and there is no guarantee that these strategies will be successful in reducing losses. It’s always advisable to have a solid understanding of options trading before implementing any adjustment strategies.
Pros and Cons of Selling Naked Calls
Selling naked calls can be a high-risk, high-reward options trading strategy. Here are some potential pros and cons to consider:
- Potential for high profits: Selling naked calls can be very profitable if the price of the underlying asset stays below the strike price and the option expires worthless, allowing the seller to keep the premium as profit.
- Flexibility: Selling naked calls allows traders to make money even if the market is relatively flat or stagnant, as long as the price of the underlying asset stays below the strike price.
- Lower capital requirements: Compared to other options trading strategies, selling naked calls requires less upfront capital since the seller does not need to own the underlying asset.
- Unlimited potential losses: One of the biggest risks of selling naked calls is that the seller is exposed to unlimited potential losses if the price of the underlying asset rises significantly above the strike price. This can result in substantial losses that exceed the premium received from selling the option.
- High risk: Selling naked calls is considered a high-risk strategy because the potential for losses is so great. It is generally recommended only for experienced traders who are comfortable taking on significant risk.
- Margin requirements: Selling naked calls typically requires traders to post a significant amount of collateral, known as margin, in order to cover potential losses. This can tie up a trader’s capital and limit their ability to make other trades.
Overall, selling naked calls can be a powerful tool for experienced options traders looking for potentially high profits in a flat or declining market. However, it’s important to weigh the potential benefits against the significant risks and margin requirements involved in this strategy.
The Bottom Line
In conclusion, selling naked calls can be a lucrative but high-risk options trading strategy. It involves selling call options without owning the underlying stock, and the potential profit is limited to the premium received. However, the risk is unlimited, as the seller could potentially face significant losses if the stock price rises sharply.
While it may not be suitable for all traders, those who are experienced and have a thorough understanding of the market dynamics may find selling naked calls to be a valuable addition to their trading arsenal. As with any investment strategy, careful analysis and a disciplined approach are essential for success.