In-The-Money Naked Call Explained

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Short Call (Naked Call) Options Trading Strategy Explained

Published on Wednesday, April 18, 2020 | Modified on Wednesday, June 5, 2020

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Short Call (Naked Call) Options Strategy

Strategy Level Advance
Instruments Traded Call
Number of Positions 1
Market View Bearish
Risk Profile Unlimited
Reward Profile Limited
Breakeven Point Strike Price of Short Call + Premium Received

Short Call (or Naked Call) strategy involves the selling of the Call Options (or writing call option). In this strategy, a trader is Very Bearish in his market view and expects the price of the underlying asset to go down in near future. This strategy is highly risky with potential for unlimited losses and is generally preferred by experienced traders.

The strategy involves taking a single position of selling a Call Option of any type i.e. ITM or OTM. These naked calls are also known as Out-Of-The-Money Naked Call and In-The-Money Naked Call based on the type you choose. This strategy has limited rewards (max profit is premium received) and unlimited loss potential. When the trader goes short on call, the trader sells a call option and earn profits if the price of the underlying asset goes down. The trader receives the premium when he sells the call option. This premium is the maximum profit trader gets in case the price of underlying asset falls.

Let’s assume you are bearish on NIFTY and expects its price to fall. You can deploy a Short Call strategy by selling the Call Option of NIFTY. If the price of NIFTY shares falls, the call option will not be exercised by the buyer and you can retain the premium received. However, if the price of NIFTY rises, you will start losing money significantly and rapidly on every rise.

This strategy has unlimited risk and limited rewards.

How to use the short call options strategy?

The short call strategy looks like as below for NIFTY which is currently traded at в‚№10400 (NIFTY Spot Price):

ITM Naked Call Order – NIFTY

Orders NIFTY Strike Price
Sell 1 ITM Call NIFTY18APR10200CE

Suppose NIFTY shares are trading at 10400. If we are expecting the price of NIFTY to go down in near future, we sell 1 NIFTY Call Option to implement this strategy.

If NIFTY falls as we expected, the call options will not be exercised by buyer and we will keep the premium received at the time of selling the call option. This is also the maximum profit in this strategy.

If NIFTY rises, the losses are unlimited. This makes it extremely risky strategy. This strategy should be used very carefully with bracket orders (stop loss).

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When to use Short Call (Naked Call) strategy?

It is an aggressive strategy and involves huge risks. It should be used only in case where trader is certain about the bearish market view on the underlying.

Example

Example 1 – Stock Options (OTM Naked Call)

Let’s take a simple example of a stock trading at в‚№48 (spot price) in June. The option contracts for this stock are available at the premium of:

Lot size: 100 shares in 1 lot

  1. Sell July 50 Call = 100 * 3 = в‚№300 Premium Received

Net Credit: в‚№300

Now let’s discuss the possible scenarios:

Scenario 1: Stock price remains unchanged at в‚№48

  • Sell July 50 Call: Expires Worthless
  • Net credit was в‚№300 which was received as premium initally.
  • Total profit = в‚№300 as we keep the premium.

The total profit of в‚№300 is also the maximum profit in this strategy. This is the amount you received as premium at the time you enter in the trade.

Scenario 2: Stock price goes up to в‚№68

  • Sell July 50 Call expires in-the-money with an intrinsic value of (50-68)*100 = -в‚№1800
  • Net credit was в‚№300 which was received as net premium.
  • Total Loss = -1800 + 300 (Premium Received) = -в‚№1500

In this scenario, we lost total в‚№1500. The loss could be significantly higher if the price of the stock keeps rising further.

Scenario 3: Stock price goes down to в‚№28

Same as scenario 1:

  • Sell July 50 Call: Expires Worthless
  • Net credit was в‚№300 which was received as premium initally.
  • Total proft = в‚№300 as we keep the premium.

Example 2 – Bank Nifty

Short Call Example Bank Nifty
Bank Nifty Spot Price 8900
Bank Nifty Lot Size 25
Short Call Options Strategy
Strike Price(в‚№) Premium(в‚№) Total Premium Paid(в‚№)
(Premium * lot size 25)
Sell 1 ITM Call 8800 500 12500
Net Premium 500 12500
Breakeven(в‚№) Strike price of the Short Call + Net Premium
(8800 + 500)
9300
Maximum Possible Loss (в‚№) Unlimited Unlimited
Maximum Possible Profit (в‚№) Net Premium Received * Lot Size
(500)*25
12500
On Expiry Bank NIFTY closes at Net Payoff from 1 ITM Call Sold (в‚№) @8800 Net Payoff (в‚№)
8800 0
(8800-8800)*25
12500
12500-0
9000 -5000
(8800-9000)*25
7500
12500-5000
9200 -10000
(8800-9200)*25
2500
12500-10000
9400 -15000
(8800-9400)*25
-2500
12500-15000
9600 -20000
(8800-9600)*25
-7500
12500-20000

Market View – Bearish

When you are expecting the price of the underlying or its volatility to only moderately increase.

Actions

  • Sell Call Option

Breakeven Point

Strike Price of Short Call + Premium Received

Break even is achieved when the price of the underlying is equal to total of strike price and premium received.

Risk Profile of Short Call (Naked Call)

Unlimited

There risk is unlimited and depend on how high the price of the underlying moves.

Reward Profile of Short Call (Naked Call)

Limited

The profit is limited to the premium received.

Why naked call writing is risky compare to Covered call?

I know that with a covered call you own the underlying and sell a call and with a naked call you don’t own the underlying. Either way, if the underlying finishes in-the-money, you are assigned and you have to sell the underlying shares at the strike price.

What I don’t get it why a naked call is so much riskier than a covered call writing?

5 Answers 5

If the buyer exercises your option, you will have to give him the stock. If you already own the stock, the worst that can happen is you have to give him your stock, thus losing the money you spend to buy it. So the most you can lose is what you already spent to buy the stock (minus the price the buyer paid for your option).

If you don’t own the stock, you will have to buy it. But if the stock skyrockets in value, it will be very expensive to buy it. If for instance you buy the stock when it is worth $100, sell your covered call, and the next day the stock shoots to $1000, you will lose the $100 you got from the purchase of the stock. But if you had used a naked call, you would have to buy the stock at $1000, and you would lose $900.

Since there is no limit to how high the stock can go, there is no limit to how much money you may lose.

There is unlimited risk in taking a naked call option position. The only risk in taking a covered call position is that you will be required to sell your shares for less than the going market price.

I don’t entirely agree with the accepted answer given here. You would not lose the amount you paid to buy the shares.

Naked Call Option

Suppose take a naked call option position by selling a call option. Since there is no limit on how high the price of the underlying share can go, you can be forced to either buy back the option at a very high price, or, in the case that the option is exercised, you can be force. to buy the underlying shares at a very high price and then sell them to the option holder at a very low price.

For example, suppose you sell an Apple call option with a strike price of $100 at a premium of $2.50, and for this you receive a payment of $250.

Now, if the price of Apple skyrockets to, say, $1000, then you would either have to buy back the option for about $90,000 = 100 x ($1000-$100), or, if the holder exercised the option, then you would need to buy 100 Apple shares at the market price of $1000 per share, costing you $100,000, and then sell them to the option holder at the strike price of $100 for $10,000 = 100 x $100. In either case, you would show a loss of $90,000 on the share transaction, which would be slightly offset by a $250 credit for the premium you received selling the call. There is no limit on the potential loss since there is no limit on how high the underlying share price can go.

Covered Call Option

Consider now the case of a covered call option. Since you hold the underlying shares, any loss you make on the option position would be “covered” by the profit you make on the underlying shares.

Again, suppose you own 100 Apple shares and sell a call option with a strike price of $100 at a premium of $2.50 to earn a payment of $250.

If the price of Apple skyrockets to $1000, then there are again two possible scenarios. One, you buy back the option at a premium of about $900 costing you $90,000. In order to cover this cost you would then sell your 100 Apple shares at the market price of $1000 per share to realise $100,000 = 100 x $1000. On the other hand, if your option is exercised, then you would deliver your 100 Apple shares to the option holder at the contracted strike price of $100 per share, thus receiving just $10,000 = 100 x $100. The only “loss” is that you have had to sell your shares for much less than the market price.

The math in these answers and comments is correct but most have mistakenly compared the opportunity risk of a covered call with the upside short risk of a naked call (the underlying rising in both positions).

Comparing the two properly requires defining whether to strike price sold is in-the-money, at-the-money, or out-of–the-money . and the answer will vary depending on which one is chosen. I’m not going to dissect all three. Since people tend to sell OTM covered calls more often than not, I’m going to go with OTM and my answer is going to set some hair on fire (g).

On an expiration basis, if you sell a naked call, it doesn’t become problematic until the underlying goes ITM. You have a buffer of the distance up to the strike price plus the premium received. For a covered call, if the underlying begins dropping, you lose on it immediately and your only buffer is the amount of premium received. IOW, in terms of risk, the naked call will outperform the covered call by the distance from underlying price to the strike price written. Well, sort of.

The limiting factor is that the underlying can only fall to zero whereas it can rise significantly more than that. Many quote that potential rise as unlimited but practically speaking, no stock has ever gone to infinity. Realistically, the naked call has upside less risk than a covered call until the amount of price rise is equal to the underlying’s price plus the distance to strike. Since words are often not as clear as numbers, consider an example:

XYZ is $20. Compare selling a $25 covered call for $1 with just selling that call naked. The covered call loses $19 if it goes to zero, a drop of 20 points. The naked $25 call doesn’t lose 19 points until the underlying hits $45 or 25 points higher. Within that price range, which is riskier? For equidistant moves in either direction, the covered call is riskier. However, above 45 it’s a different story.

There are other factors to be considered such as the market rising for longer periods than falling but those are decisions as to which strategy is more appropriate for the market you’re in. In the narrow confines of equidistant price movement in either direction, a naked call is less risky than a covered call.

If you really want to be clever, use vertical spreads instead of a B/W or a naked call, eliminating the bulk of the potential loss in either direction :->)

Puts and Calls: Covered and Naked

Puts and calls can be naked or covered, and their deployment depends on the trader’s strategy and expectations for the underlying stock. The following section “covers” the primary rationales for buying or writing puts or calls.

Call Options (Calls)

Call options sold are considered “covered” when the writer owns a number of the underlying shares equal to the number of contracts written times 100 (for standard options), because the obligation to deliver the shares if assigned is covered. Thus it is the delivery obligation that is covered.

Calls are “naked” (“uncovered”) when the writer does not own the underlying shares. The risk in a naked call position is that the stock price advances, forcing the writer to buy the stock at market at a price higher (perhaps much higher) than at trade entry. The risk from naked call writing is, at least theoretically, unlimited, because the stock has no limit theoretically to how high it could rise.

Figure 2.7

When the stock is $29, you write the current-month $30 Call for a $1.00 premium, expecting the stock to sell off. The call is naked (uncovered) because you do not own the stock. This looks like $1.00 in free premium, doesn’t it?

But news on the stock sends it to $50. You have a real problem. The $30 Call was out of the money when you wrote it, but is now $20 in the money. It will of course be exercised, requiring you to deliver the stock at the $30 strike price.

The problem is that you don’t own it. You’ll have to go into the market and buy the stock for $50 (or more), just so you can sell it for $30. How did you do on the trade?

– $50.00 Bought the stock

+ 30.00 Sold the stock

+ 1.00 Premium realized

– $19.00 Loss

That’s a loss of $19 per share, or $1,900 per call contract. That’s quite a hickey, as brokers say.

You could wait (hope) for a pullback in the stock in order to buy it cheaper than $50 or buy back the call at a lower price, but that is a risky proposal, since the stock might continue up. Your brokerage firm will not be so sanguine about the situation and how you handle it, since it (or its clearing firm) must make the trade good by delivering the underlying shares upon assignment if you cannot.

For this reason, naked call writing usually is restricted to traders with real experience and minimum net account equity of $100,000 or more.

Put Options (Puts)

Puts are considered “covered” when the writer has a short position in the underlying stock. The combination of short stock and short put creates a position that is the synthetic equivalent of, and presents the same risk/reward profile as a naked call. If your broker will not allow you to write naked calls, you will not be allowed to place a covered put trade, either. Note that a long stock position does not cover a short put, since assignment on a short put requires you to buy, not deliver, the stock.

A naked put is one not covered by short stock. Many, including some brokers, consider naked puts unduly risky, but as explained in the Naked Puts section below, the covered call is just a synthetic way of creating a naked put position. The positions present an identical risk/reward profile. The maximum possible risk is that the stock goes to zero. The trader risks the stock price less the premium received (covered call) or the put strike less the premium received (naked put). Thus if your broker allows you to write covered calls, it should also allow you to write naked puts, including in an IRA account, though even if permitted, the broker may require a higher level of options approval to transact naked puts in an IRA or 401(k) account, which can be managed automatically by a company like Blooom, which specializes in digital automated management of 401(k)s.

As will be discussed in more detail below, another use for naked puts is to purchase stock at a discount. Smart investors looking to acquire a particular stock for a portfolio will often sell puts on the shares, hoping the shares will be “put to them, the purchase price being reduced by the amount of the premium received. This is a technique far more investors should use to buy stock at a “discount.”

Naked puts can be written repeatedly until the stock is acquired due to exercise of the put. It can take a while, though. I have sold naked puts for months and never acquired the stock!

Example: When XYZ shares are $22, an investor might sell the current-month 20P for a $1.00 premium, hoping the shares are put to him. If the shares are below $20 at expiration the put will be exercised, and the investor would in that case buy the shares at the $20 put strike. But the $1.00 premium received reduces the cost to $19: far better than having bought it at $22. Sure, the stock had dropped below $20 temporarily, but the investor wanted the stock. Had the stock not been put to him, the $1.00 premium would have been pure profit.

The author has no position in any of the stocks mentioned. Financhill has a disclosure policy. This post may contain affiliate links or links from our sponsors.

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