Naked call

From Wikipedia, the free encyclopedia
Jump to: navigation, search

A naked call occurs when a speculator writes (sells) a call option on a security without ownership of that security. It is one of the riskiest options strategies because it carries unlimited risk as opposed to a naked put where the maximum loss occurs if the stock falls to zero. A naked call is the opposite of a covered call.[1]

The buyer of a call option has the right to buy a specific number of shares at a strike price before an expiration date from the call option seller. Since a naked call seller does not have the stock in case the option buyer decides to exercise the option, the seller has to buy stock at the open market in order to deliver it at the strike price. Since the share price has no limits to how far it can rise, the naked call seller is exposed to unlimited risk.

Speculators who have an appetite for risk might buy a call option when they believe the price of the stock will go up and they do not have the cash available to pay for the stock at its current price. A disadvantage of the call option is that it eventually expires.

Speculators may sell a "naked call" option if they believe the price of the stock will decline or be stagnant. The risk of selling the call option is that risk is unlimited if the price of the stock goes up.[2]

Examples[edit]

Stock XYZ is trading at $47.89 per share DEC 50 Call is trading at $1.25 premium

Investor A ("A") forecasts that XYZ will not trade above $50.00 per share before December, so A sells the 10 DEC 50 Calls for $1,250.00 (each option contract controls 100 shares). A doesn't buy the stock, therefore A's investment is considered naked.

Meanwhile, Investor B ("B") forecasts that XYZ will go above $50.00 per share before December, so B purchases those 10 calls from A for $1,250.00. At expiration of the option, consider 4 different scenarios where the share price drops, stays the same, rises moderately or surges.

Assuming there are no other costs or taxes affecting the contract, when A) the date is December 1 or B) prices rise above $50.00, one of two general things happen: 1) B makes a 100% loss, 2) B profits by the same amount of A's net loss.

The following are four scenarios for the example:

Scenario 1[edit]

Stock drops to $43.25 DEC 50 Call expires worthless

A keeps the entire premium of $1,250.00 B makes a 100% loss

Scenario 2[edit]

Stock stays at $47.89 DEC 50 Call expires worthless

A keeps the entire premium of $1,250.00 B makes a 100% loss

Scenario 3[edit]

Stock rises to $52.45 DEC 50 Call is exercised

A is forced to buy 1,000 shares of XYZ for $52,450.00 and immediately sell them at $50,000.00 for a loss of $2,450.00. Since A received the premium of $1,250.00 before, A's net loss is $1,200.00. B buys 1,000 shares of XYZ for $50,000.00 and now is able to sell them at open market for $52.45 per share, if B so chooses. B's net gain is $1,200.00 (same as A's loss excluding commission costs)

Scenario 4[edit]

Stock surges to $75.00 on a news announcement. DEC 50 Call is exercised.

A is forced to buy 1,000 shares of XYZ for $75,000.00 and immediately sell them at $50,000.00 for a loss of $25,000.00. Since A received the premium of $1,250.00 before, A's net loss is $23,750.00. B buys 1,000 shares for $50,000.00 and paid the premium of $1,250.00 before. These shares are now worth $75,000.00 on the open market. B's net gain is $23,750.00 (same as A's loss, if commission costs are omitted).

References[edit]