You know that a covered call is a position where you sell call options against a stock that you presently own. If you need a refresher on a covered call read this. An uncovered call or naked call, is a position that is created by selling call options when you don’t currently own the underlying stock.
When selling a naked call option contract you are expecting the stock price to decline or stay relatively flat for the foreseeable future. Remember what a call option is. The owner of the call option has the right to buy the stock at the predefined strike price.
By selling that right to another individual without actually owning the stock, you are taking on a lot of risk.
Why is a naked call more risky?
After selling the naked call you still receive the premium as you would with any other option. The difference here is that you have no built in protection if the stock doesn’t perform to your expectation.
Say you sold a call option at the $15 strike price. Upon selling that option you received $1.00 (for clarity, remember that options are always sold in shares of 100… or one contract). The stock is currently trading at $16 per share. You believe the stock price will be below $15 by the time options expiration rolls around. If the stock is at or beneath the strike price of $15 then your position was a profitable one.
What happens if the stock is above the strike at expiration?
This is where the unlimited risk comes in. Looking at our example above, should the stock close anywhere above $15 your position becomes a losing one. How far above $15 the stock is at expiration determines exactly how much of a loss you will be in for.
Since you sold your call options at the $15 strike price, you guaranteed the buyer of those options that you would sell 100 shares of stock for every contract they bought, for $15 each.
In short, your losses would be a minimum of $1,500 if the stock didn’t close below your desired strike price.
If this stock stayed at the $16 price it was when you sold the naked calls, you would have to purchase 100 shares of stock for $16 each and then sell them for only $15! That’s a $1,500 loss in return for a pocketing a mere $100. This is one of the scenarios that can prompt a call from your broker demanding you deposit additional funds to cover your position.
A covered call protects the downside.
Selling a naked call can be a position where you take on unnecessary risk. By simply owning shares of the stock you wrote calls against, you can easily fulfill your obligations should the options be exercised. The risk you take on should be compensated by the premium or income you receive. This goes not only for option writing but for any trading or investing strategy.
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