Naked Call
Candlefocus EditorWhen a call option is sold, the seller receives a premium, which is the price of the option minus the strike price. If the underlying security stays the same in price or increases, then the option will expire and the seller will simply keep the premium as their return. However, the risk of selling an uncovered call is that if the security rises in price, then the option can be exercised and the seller will have unlimited potential losses.
Investors who sell an uncovered call are typically looking to benefit from a decrease in the price of the underlying security. If the stock stays at the same level or lower, then the seller will simply keep the premium as their return. However, the risk of selling an uncovered call is that if the stock price rises, then the option will be exercised and the seller will suffer a potential loss as the stock rises and the option is exercised.
If the stock price is higher than the strike price plus the premium paid for the option, then the option is considered to be in-the-money and the holder can exercise. The risk of selling the call is effectively unlimited and the cost of the call option will decrease incrementally with rises in the underlying stock price. As a result, many investors use this strategy only when they are moderately bearish on the security.
When selling a naked call, the investor’s maximum possible return for the trade is limited to the premium received at the time of sale. Furthermore, the investor must also be mindful of the potential losses in the event that the underlying asset increases in price over and above their breakeven point. The breakeven point for the seller is the strike price plus the premium received.
In summary, the risk involved in selling naked calls is that the price of the underlying asset may increase above the strike price or the premium, or both. While an investor may potentially benefit from an increase in the premium or a decrease in the stock price, they are ultimately limited in their returns and open to potentially unlimited losses. Consequently, an uncovered call strategy must be used very carefully and only when an investor has a moderate level of bearish sentiment toward the underlying asset.