Naked call

This article needs additional citations for verification. Please help improve this article by adding citations to reliable sources. Unsourced material may be challenged and removed. (January 2007)

This article provides insufficient context for those unfamiliar with the subject. Please help improve the article with a good introductory style. (October 2009)

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.

Examples

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 per share before December, so A sells the 10 DEC 50 Calls for $1,250 (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, so B purchases those 10 calls from A for $1,250. At expiration of the option, consider 4 different scenarios where the share price drops, stays the same, rises moderately or surges.

The following are four scenarios for the example:

Scenario 1

Stock drops to $43.25 DEC 50 Call expires worthless

A keeps the entire premium of $1,250 B makes a 100% loss

Scenario 2

Stock stays at $47.89 DEC 50 Call expires worthless

A keeps the entire premium of $1,250 B makes a 100% loss

Scenario 3

Stock rises to $52.45 DEC 50 Call is exercised

A is forced to buy 1,000 shares of XYZ for $52,450 and immediately sell them at $50,000 for a loss of $2,450. Since A received the premium of $1,250 before, A's net loss is $1,200. B buys 1,000 shares of XYZ for $50,000 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 (same as A's loss excluding commission costs)

Scenario 4

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 and immediately sell them at $50,000 for a loss of $25,000. Since A received the premium of $1,250 before, A's net loss is $23,750. B buys 1,000 shares of XYZ for $50,000 and now is able to sell them at open market for $75.00 per share, if B so chooses. B's net gain is $23,750 (same as A's loss excluding commission costs)

References