Naked Call

Amsterdam Stock Exchange (AEX) .AS Definition

What is a naked call?

Bare call is an option strategy in which an investor sells (sells) call options on the open market without owning the underlying security. This contrasts with a hedged buying strategy, where the investor owns the underlying security on which the call options are sold. This strategy is sometimes called “uncovered call” or “short call”.

Understanding the naked call

A naked call gives an investor the opportunity to generate income without actually having the underlying security. Essentially, the premium received is the only reason for the subscription of an uncovered purchase option. It is inherently risky because the potential for upward profit is limited and, in theory, the potential for downward loss is unlimited.

  • The maximum gain is the premium that the author of the option receives in advance, which is generally credited to his account. Thus, the objective of the author is to expire the worthless option.
  • The maximum loss is theoretically unlimited since there is no limit on the increase in the price of the underlying security. However, in more practical terms, the options seller will likely buy them back well before the price of the underlying goes too far above the strike price, depending on its risk tolerance and stop loss parameters.
  • The breakeven point for the writer is calculated by adding the premium received and the strike price for the bare call.
  • An increase in implied volatility is not desirable for the author because the probability that the option is in the money and therefore exercised also increases.
  • Since the author of the option wants the bare call to expire outside the course, the passage of time or the decrease of time will have a positive impact on this strategy.
  • Margin requirements, of course, tend to be quite high given the unlimited risk potential of this strategy.

Because of the risk involved, only experienced investors who firmly believe that the price of the underlying security will fall or remain stable should undertake this advanced strategy. Margin requirements are often very high for this strategy due to the propensity for indefinite losses, and the investor may be forced to buy stocks on the open market before expiration if the margin thresholds are exceeded . The advantage of the strategy is that the investor could receive income in the form of premiums without putting up a lot of initial capital.

Key points to remember

  • Bare call is an option strategy in which the investor sells (sells) call options without owning the underlying security.
  • A naked call has limited upside profit potential and, in theory, unlimited downside loss potential.
  • The neutral point of a naked call for the writer is its strike price plus the premium received.

Using bare calls

Again, there is a significant risk of loss with the writing of uncovered calls. However, investors who firmly believe that the price of the underlying security, typically a stock, will go down or stay the same can purchase call options to earn the premium. If the share remains below the exercise price between the time the options are sold and their expiration date, the option writer keeps the entire premium less commissions.

If the share price exceeds the exercise price on the expiration date of the options, the buyer of the options may ask the seller to deliver shares of the underlying stock. The option seller will then have to enter the open market and buy these shares at the market price to sell them to the option buyer at the exercise price of the options. If, for example, the exercise price is $ 60 and the open market share price is $ 65 at the time the options contract is exercised, the option seller will suffer a loss of $ 5 per share less premiums received.

The premium collected will somewhat compensate for the loss on the stock but the potential loss can still be very significant. For example, let’s say an investor thought that the strong bullish wave from Amazon.com (AMZN) was over when it finally stabilized in March 2020 at around $ 852 per share. He subscribed to a call option with an exercise price of $ 865 and a maturity in May 2020. However, after a short break, the title resumed its rally and at the end of mid-May, the title reached $ 966. The potential liability was the strike price of $ 966 minus the strike price of $ 865, which yielded $ 101 per share. This is offset by the premium received at the start.

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