Naked Call Explained (Simple Guide)
How would you like to earn a significant return off of a stock that drops in value or stays the same? If so, then consider the naked call strategy.
A naked call, or a short call, involves selling an option when you don’t own either the option or the underlying stock. The idea is to sell it first, then buy it back later at a lower price and pocket the profit.
Alternatively, you can just let the call expire worthless and keep all the money you earned when you sold it.
In this guide, I’ll go over the concept of a naked call so that you can determine if it’s a trading strategy that’s in line with your financial goals.
What Is a Naked Call?
Traders often sell options when they hold a position in the underlying stock.
For example, if you own 100 shares of IBM, you can sell somebody else an option to buy those shares on a specific date at a specific price.
In the case of a naked call, you’re selling the option without owning any shares of IBM stock. That’s a distinction with a huge difference.
Why? Because if the trade goes against you (in this case, if IBM moves higher), then your losses could be significant. You’ll either have to buy back the option you sold at a higher price or buy shares of IBM just so you can sell them for a loss to the other person.
Naked calls offer limited return but potentially unlimited risk.
The return is limited because the underlying stock can only drop to $0 per share. It can’t go any lower.
The risk is unlimited because there’s no “maximum” price for the stock. It can theoretically go up forever.
When Would You Use a Naked Call?
Use a naked call when you think the underlying stock is going down or will stay the same over time.
A naked call is like shorting a stock. You make money when the underlying price drops.
However, you can also make money if the price stays the same.
Why? Because options are subject to time decay. Since they have an expiration date, they normally drop in value over time, all other things being equal.
If you buy an option that’s worth $5.00 today and the expiration date is a month out. You’ll notice that the option decreases in value as it gets closer to expiration, even if the underlying stock price stays the same or ticks up slightly.
When you short calls, you’re letting time work in your favor. The longer you hold the option without a significant upside swing in the underlying stock, the more likely you’ll earn a positive return.
Read Also: What is a naked put option?
How Does a Naked Call Work?
Before you even think about opening a naked call position, make sure that you have a margin account with your online brokerage.
In fact, you’ll likely find that you need significant margin to short a call option. That’s because the risk is unlimited.
Once you have your margin requirement satisfied, look for a stock that you think will go down in value or stay flat over the next month or so. Look at available call options for that time period.
Next, identify the right strike price. That’s the price that you think the stock will not go above prior to expiration.
Finally, sell the call option for that strike price at that expiration.
If the underlying stock stays the same or drops in price prior to expiration, the option will expire worthless. That’s a good thing in this case because you keep the money you earned when you sold the call.
On the other hand, if the stock rises in value beyond the strike price, you’ll either have to buy back the option for a loss or buy the underlying stock and sell it to the other party for a loss.
Real Life Example Using a Naked Call?
Let’s say Intel is trading at $46 per share. You think it’s going to stay flat or drop slightly over the next month, so you decide to short a call option.
You look at the options that expire about a month from now. The $49 call option is currently trading for $0.68.
You’re convinced that Intel won’t go higher than $49 over the next month, so you sell the option. That earns you $68 because options are traded in blocks of 100 shares ($0.68 x 100 = $68).
As time passes, Intel pops up to $48 per share prior to expiration. You get nervous, but then you remember that time is on your side.
Even though the stock is going up in value, time decay eats into the value of the option. As the option decreases in value, you make money.
The stock stays right around $48 per share at expiration. Your option expires worthless.
That’s good news because you get to keep the money you earned from selling the option. In this case, that’s $68.
So even though the stock went up in value, it never crossed the strike price of $49. You made a good call and earned a positive return.
What Are Similar Strategies Related to Naked Call?
Here are a few strategies similar to a naked call:
- Long Put – Involves buying a put option instead of selling a call option. Although both strategies are profitable when the stock drops in value, there’s a key difference. Time is not on your side with a long put option. If the underlying stock price stays the same, time decay will eat into the value of the option and you’ll lose money.
- Covered Call – A covered call is like a naked call except that you own the underlying stock. You can sell that stock if the trade doesn’t go your way.
- Bear Call Spread – Similar to a naked call except that you hedge the position with a long call option at a higher strike price. That limits your loss.
Naked Call Compared to Other Options Strategies?
Many options strategies involve limited risk and limited return. A naked call involves unlimited risk.
Remember, the underlying stock can theoretically go up forever. If you’re short the call option for the stock when it skyrockets in value, your loss could be enormous. You might even wipe out your margin account.
That’s why a naked call is best left to very experienced options traders. If you haven’t yet traded naked calls, make sure you do some practice trading before putting your own money on the line.
Or, at the very least, hedge yourself with a bear call spread.
Advantages & Risks of Naked Call?
- Potential for significant returns – You can earn a much higher positive return by shorting call options than you can by shorting the underlying stocks. That’s because options use leverage.
- Time is on your side – Even if you were wrong about the underlying stock dropping in value, you can still win with a short call. If the stock price stays the same or just ticks up slightly, the option will drop in value thanks to time decay. Since you’re short the option, you make money when it drops in value.
- Potential for unlimited loss – Although you can earn significant returns with a naked call, there’s no limit to your loss. It’s best to practice with short calls before you start trading with real money.
- Margin wipe-out – You might lose a significant amount of your margin when you place a bad trade.