Naked Call Options

The Covered Call is one of the most popular option trading strategies. It is also the most conservative. This strategy involves the selling of a Call Option on an underlying stock you already own. The Call writer (seller) owns the stock he is selling the option on. If he owns 100 shares of IBM stock and wants to sell someone a Call Option. He is selling that person the right to buy his 100 shares of IBM stock at a specific price within a specified time frame. This option trade is the most basic trade and it must be completely understood. And completely understood before you move on the Naked Calls Options.

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In comparison, the Naked Call (Uncovered Call) is a Very high-risk strategy. It is not that hard to explain, buy it is difficult for many to grasp because many have such a hard time realizing they can sell something they don’t own. If writing a Covered Call means selling a Call Option on stock we actually own, then writing an Uncovered Call or Naked Call is selling a Call Option on stock we don’t own. It’s important for you to understand this and equally important to understand your limitations and the risk you put yourself at with this strategy.

 

An investor who writes a call option without owning the underlying stock is banking on a flat to bearish short-term forecast for the stock. The strategy consists of writing the call in hopes that it will lose value through Time Decay and eventually expire without reaching the Strike Price. This is my #1 strategy. If the contract period ends without the option being assigned, the Call seller keeps the entire premium initially received, and all obligations under the option contract terminate. The problem with the Naked Calls strategy is when the stock moves up more than anticipated.

 

When selling a Call Option on a stock, whether you own the stock or not, you are selling someone the right to buy that stock. If you get assigned, which means you have to deliver the stock to the Call buyer, you must sell the Call buyer the stock. If you previously own the stock you sell him the stock you already own. If you do not own the stock because you sold a Naked Call, you must acquire the stock and sell it to the Call buyer.

 

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This is so important to understand, let’s walk through this process with an example.

Joe is an options trader. Joe is interested is selling a Naked Call Option on XYZ Corp. It’s a Naked Call because Joe does not own the stock. XYZ Corp is selling on the market for $20 per share. Joe feels that XYZ Corp, in the short term, will move sideways or down. Joe is bearish on the stock. Because it’s a Naked Call, Joe does not want to sell his Call At-the-money. This would mean he sold the $20 Call on a $20 stock. He wants a little breathing room just in case he has the direction of the stock wrong and the stock moves up a bit. He knows he can get a higher premium with a Strike Price of $21 or $22 but he wants more breathing room so he is looking at the $23 Calls. Joe does not want to sell a long term option because it’s a Naked Option and he wants “Time Decay” on his side. Joe looks at the 2 week option with the Strike Price of $23. Joe looks at the premium and he sees he can get $.40. Joe put in the order to sell 10 contracts (1000 shares) of the 2 week option with the Strike Price of $23 and received a premium of $.40 per share for a total of $400.

Along comes Tom. Tom is on his computer and Tom likes the company XYZ Corp. Tom wants to buy an Option. XYZ Corp is selling on the market for $20 per share. Tom heard some news and he thinks XYZ Corp is going to spike up in the next few days. Joe is bearish on XYZ and Tom is bullish on XYZ. Tom feels in the next 2 weeks XYZ Corp can go up to $25. Tom is looking at the Option Chain for XYZ Corp and he likes the 2 week option with the Strike Price of $23. He feel in 2 weeks XYZ Corp will be at $25 so he wants the right to buy the stock at $23. If Tom buys the $23 option and the stock goes up to $25 by Expiration Date (or before) Tom would be able to buy the stock for $23 when it’s on the market for $25. He would make $2 on the stock. Remember, Joe’s order is still sitting on the computer. Tom decides to buy Joe’s 10 contract option for the $.40 premium. $400 goes from Tom’s account into Joe’s account and Tom owns the right to buy XYZ Corp from Joe. Tom bought the right to buy 1000 shares of XYZ Corp from Joe, and Joe has the obligation to sell Tom 1000 shares of XYZ Corp. The only problem is Joe does not own 1000 of XYZ Corp to sell to Tom if he decides to buy. If XYZ Corp stays below the $23 Strike Price for the next 2 week, this would be good for Joe. If XYZ Corp goes up above the $23 in the next 2 weeks, this would be bad for Joe. Below let’s examine a few scenarios with some possible moves the XYZ Corp can make.

 

  1. XYZ Corp moves down: 2 weeks go by and Joe was right. The stock moved a little sideways then went down and closed on Expiration Day at $19. This is good for Joe. He sold a Naked Call for $400 and he never had to deliver the stock. The $400 stays in his account and the deal is done. For Tom it didn’t work out as well. Tom’s prediction did not come true. He picked the direction of the stock wrong. The stock did not go up to where he can buy it from Joe so he loses his $400.
  2.  XYZ Corp moves down fast: 1 Day into the contract XYZ Corp takes a big dip. Some bad news comes out and the stock goes down to $17. Joe looks at the premium and the $23 Call down to $.02. Joe just sold the Call the day before for $.40 for a total of $400. Joe figures with just about the entire contract remaining he would buy his way out of the deal. The contract he sold for $.40 he can buy back for $.02. He received $400 and he paid $20 to end the deal. The $20 is the $.02 X 1000 shares. In 1 day his profit is $380 and the contracted is terminated.
  3. XYZ Corp moves up slow: After Joe sold the Naked Option to Tom XYZ Corp started to creep up. This was a 2 week option and by the end of the 1st week the stock went from $20 to $22. Tom is happy because the stock is moving in the direction he predicted. Joe is a little worried because the stock went up $2 and there is still a week to go before the option expires. In the 2nd week XYZ Corp continued to move up so Joe is watching closely. With 2 days left to expiration XYZ Corp is up to $22.70. Joe is very worried because he knows he has to deliver the 1000 shares at $23. With 2 days left Joe decides to buy 1000 shares of XYZ Corp for $22.70. Now Joe has a Covered Call. He now has the 1000 shares to deliver the stock if it continues up and goes over the $23 Strike Price. With 1 day left to expiration XYZ Corp takes the big jump Tom was predicting. On expiration XYZ Corp is at $26. Joe now owns the stock and he gets assigned. This is when his broker informs him that he has to sell his stock for the $23 Strike Price he agreed to in his option contract. Joe covered his Call when buying the stock. Joe bought the stock for $22.70 and was obligated to sell at $23. Joe made $.30 on the stock. On the 1000 shares thats $300 plus he made $400 with the premium. Joe made a total of $700. Deal over! Joe did nicely but Tom did better. Tom paid $400 in premium for the right to buy Joe’s stock for $23. Tom bought the 1000 from Joe at $23 and sold them on the open market for the going price of $26. Tom made $3000 on the stock sale. Considering the $400 Tom spent on the option, his profit was $2600. Both Joe and Tom were happy.
  4. XYZ Corp moves up fast over night: 2 days into the option contract XYZ takes the huge jump Tom was looking for. The only problem for Joe is the big jump happened over night. When Joe got up in the morning he looked at the early reports to see how the market will open. Before the market was  trading there was a report with great news on XYZ Corp and the stock was going to open at $27. Can this happen you ask? You better freakin believe it can happen. Joe starts to go into a cold sweat! He has a weird feeling in his stomach! Joe is panicking! Joe starts screaming in an empty house trying to get ready for work. He’s staring at the TV hoping the stocking will move down one penny at a time. If you don’t know my now, Joe has a problem. If the stock is still at $27 at expiration  Joe has to buy the stock at $27 and sell it for $23. On 1000 shares that’s a $4000 lose. To add to Joe’s anxiety he still has almost the entire 2 weeks to go before expiration. He’s wondering where the stock can end up on expiration, he’s already down $4000. In a panic he knows not what to do. In the absence of any problem solving thinking, he does nothing. The stock opens at $27 and settles down a bit. XYZ Corp fluctuates around the $26 to $27 area for a few days while Joe is glued to his computer. With about 3 minutes left to the close on expiration day Joe buys the stock at $25.50 to cover his Call. Joe gets a big feeling of relief because the unknown is over. Joe gets assigned and has to deliver the 1000 shares at $23. He takes a $2500 lose. He did collect a $400 premium so his total lose is $2100. This could have been much worse and Joe knows it. Joe reconsiders his strategy using Naked Calls. On the other hand Tom is very happy. It cost Tom $400 to get into the option contract and he made $2500 on the stock.

 

My Naked call Strategy

 

I love to Sell Naked Calls. This is my favorite Strategy. There’s one reason for selling Naked Calls and that’s to bring in premium. There are a number of reasons why I prefer Naked Call selling, and I do have a number of rules. My 1st rule is to never sell a Naked Call when news is imminent on the underlying stock. There is already too much general news coming out every day from around the world, you don’t need news coming out on the stock such as earnings to cause a big move. This would be complete gambling; you don’t need more uncertainty to an already risky strategy.

One of my main reasons I prefer selling Naked Calls is I don’t own the stock. I don’t like owning stock. I do not trust owning stock. The world is so crazy with news it’s very difficult to pick direction

I want to sell Naked Calls only for a short contract. 1 or 2 weeks, tops. I want to take advantage of the “Time Decay.” If the stock takes a quick dip I might jump out with a profit early.

I sell Naked Call $2 or $3 Out-of-the-Money. If the stock is at $25, I’ll sell the $27 or $28 Calls, this gives me a little cushion. If the stock starts to move up it gives me some time to buy the stock to cover my Call. I never want to sell a Naked Call At-the-Money or In-the-Money. Complete gambling!

I want to sell Naked Calls when I feel the underlying stock will run flat or down for a little while. The more the stock moves sideways or down the more the time decay works for me. Plenty of times, as the Time Value melts away, I buy my way out of the Call at a lower price than what I sold for. If I sell a Call and receive a $500 premium and the time value melts away I might buy my way out of the contract for $200. That would be a $300 profit.

If the premium decays away as a result of the time passage and the stock moving down, I examine the situation. If the premium is cut in half and I still have half the time left to the contract, I’ll buy my way out and call it a day.

When I get into trouble like in example 4 above, I might do a “Roll Out.” This is another strategy you must read about. The page is under “Educational.”

The bottom line is, when selling Naked Calls you better have risk tolerance and you better be near your computer. The situation explained in example 4 above happens more than you would think. Murphy Law!