Out-Of-The-Money Naked Call Explained

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Naked Call

What is a Naked Call?

A naked call is an options strategy in which an investor writes (sells) call options on the open market without owning the underlying security. This stands in contrast to a covered call strategy, where the investor owns the underlying security on which the call options are written. This strategy is sometimes referred to as an “uncovered call” or a “short call.”

Understanding Naked Call

A naked call gives an investor the ability to generate revenue without actually owing the underlying security. Essentially, the premium received is the sole motive for writing an uncovered call option. It is inherently risky as there is limited upside profit potential and, in theory, unlimited downside loss potential.

  • The maximum gain is the premium that the option writer receives upfront, which is usually credited to their account. So, the goal for the writer is to have the option expire worthless.
  • The maximum loss is theoretically unlimited because there is no cap on how high the price of the underlying security can rise. However, in more practical terms, the seller of the options will likely buy them back well before the price of the underlying rises too far above the strike price, based on his/her risk tolerance and stop-loss settings.
  • The breakeven point for the writer is calculated by adding the premium received and the strike price for the naked call.
  • A rise in implied volatility is not desirable to the writer as the probability of the option being in-the-money, and thus being exercised, also increases.
  • Since the option writer wants the naked call to expire out-of-the-money, the passage of time, or time decay, will have a positive impact on this strategy.
  • Margin requirements, understandably, tend to be quite steep given the unlimited risk potential of this strategy.

As a result of the risk involved, only experienced investors who strongly believe that the price of the underlying security will fall or remain flat should undertake this advanced strategy. The margin requirements are often very high for this strategy due to the propensity for open-ended losses, and the investor may be forced to purchase shares on the open market prior to expiration if margin thresholds are breached. The upside to the strategy is that the investor could receive income in the form of premiums without putting up a lot of initial capital.

Key Takeaways

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

Using Naked Calls

Again, there is significant risk of loss with writing uncovered calls. However, investors who strongly believe the price for the underlying security, usually a stock, will fall or stay the same can write call options to earn the premium. If the stock stays below the strike price between the time the options are written and their expiration date, then the options writer keeps the entire premium minus commissions.

If the price of the stock rises above the strike price by the options expiration date then the buyer of the options can demand the seller to deliver shares of the underlying stock. The options seller will then have to go into the open market and buy those shares at the market price to sell them to the options buyer at the options strike price. If, for example, the strike price is $60 and the open market price for the stock is $65 at the time the options contract is exercised, the options seller will incur a loss of $5 per share of stock less the premium received..

Out Of The Money (OTM)

What Is Out Of the Money (OTM)?

Out of the money (OTM) is a term used to describe an option contract that only contains intrinsic value. These options will have a delta less than 50.0.

An OTM call option will have a strike price that is higher than the market price of the underlying asset. Alternatively an OTM put option has a strike price that is lower than the market price of the underlying asset.

OTM options may be contrasted with in the money (ITM) options.

Key Takeaways

  • Out of the money means an option has no intrinsic value, only extrinsic value.
  • A call option is OTM if the underlying’s price is below the strike price. A put option is OTM if the underlying’s price is above the strike price.
  • An option can also be in the money or at the money.
  • OTM options are less expensive than ITM or ATM options. This is because ITM options have intrinsic value, and ATM options are very close to having intrinsic value.

Understanding Out Of The Money Options

Option Basics

For a premium, stock options give the purchaser the right, but not the obligation, to buy or sell the underlying stock at an agreed-upon price, known as the strike price, before an agreed-upon date, known as the expiration date.

An option to buy an underlying asset is a call option, while an option to sell an underlying asset is a put option. A trader may purchase a call option if they expect the underlying asset’s price to exceed the strike price before the expiration date. Conversely, a put option enables the trader to profit on a decline in the asset’s price. Because they derive their value from that of an underlying security, options are derivatives.

An option can be OTM, ITM or at the money (ATM). An ATM option is one where the strike price and price of the underlying are equal.

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Out of the Money Options

You can tell if an option is OTM by determining where the current price of the underlying is in relation to the strike price of that option. For a call option, if the underlying price is below the strike price, that option is OTM. For a put option, if the underlying’s price is above the strike price, then that option is OTM. An out of the money option has no intrinsic value, but only possesses extrinsic or time value.

Being out of the money doesn’t mean a trader can’t make a profit on that option. Each option has a cost, called the premium. A trader could have bought a far out of the money option, but now that option is moving closer to being in the money (ITM). That option could end up being worth more than the trader paid for the option, even though it is currently out of the money. At expiry, though, an option is worthless if it is OTM. Therefore, if an option is OTM, the trader will need to sell it prior to expiry in order to recoup any extrinsic value that is possibly remaining.

Consider a stock that is trading at $10. For such a stock, call options with strike prices above $10 would be OTM calls, while put options with strike prices below $10 would be OTM puts.

OTM options are not worth exercising, because the current market is offering a trade level more appealing than the option’s strike price.

Out of the Money Options Example

A trader wants to buy a call option on Vodafone stock. They choose a call option with a $20 strike price. The option expires in five months and costs $0.50. This gives them the right to buy 100 shares of the stock before the option expires. The total cost of the option is $50 (100 shares * $0.50), plus a trade commission. The stock is currently trading at $18.50.

Upon buying the option, there is no reason to exercise it because by exercising the option they have to pay $20 for the stock, when they can currently buy it at a market price of $18.50.

This option is OTM, but that doesn’t mean it is worthless yet. The trader just paid $0.50 for the potential that the stock will appreciate above $20 within the next five months.

If the option is OTM at expiry it is worthless, but prior to expiry, that option will still have some extrinsic value which is reflected in the premium or cost of the option. The price of the underlying may never reach $20, but the premium of the option may increase to $0.75 or $1 if it gets close. Therefore, the trader could still reap a profit on the out of the month option itself by selling it at a higher premium than they paid for it.

If the stock price moves to $22—the option is now ITM—it is worth exercising the option. The option gives them the right to buy at $20, and the current market price is $22. The difference between the strike price and the current market price is known as intrinsic value, which is $2.

In this case, our trader ends up with a net profit or benefit. They paid $0.50 for the option and that option is now worth $2. They net $1.50 in profit or advantage.

But what if the stock only rallied to $20.25 when the option expired? In this case, the option is still ITM, but the trader actually lost money. They paid $0.50 for the option, but the option only has $0.25 of value now, resulting in a loss of $0.25 ($0.50 – $0.25).

What Is a Naked Call?

Here’s the basic setup of a naked call, along with how to calculate the position’s maximum gain, maximum loss, and breakeven point.

There are plenty of ways to profit on a stock’s movement, beyond investing in the actual stock itself. Options provide a nearly endless array of strategies, due to the countless ways you can combine buying and selling call option(s) and put option(s) at different strike prices and expirations.

A call is an options contract that gives the owner the right to purchase the underlying security at the specified strike price at any point up until expiration. A put is an options contract that gives the owner the right to sell the underlying asset at the specified strike price at any point up until expiration.

When it comes to speculative options trading strategies, it doesn’t get riskier than naked calls.

Selling something you don’t have

A naked call is when a speculator or investor writes a call option without having a position in the underlying stock itself. To set up a naked call, an investor simply sells a call option without owning the underlying stock. The short side of a call option is required to deliver shares of the underlying stock if the option is exercised.

If you already have the stock, then it’s generally not a problem to deliver it if the option is exercised, which is referred to as a covered call. Covered calls are one of the most conservative and low-risk options strategies out there.

However, if you don’t already own the stock and you must deliver it, then you must go out and purchase the stock at prevailing market prices. But since stock prices theoretically have no maximum, the potential risks are enormous.

Image source: The Motley Fool.

For example, if a stock is trading at $50, and an investor does not believe that the stock will rise above $60, then the investor may sell a naked $60 call. Let’s say that the premium received for the call is $4.

Maximum loss: unlimited

Theoretically, there is no upper-bound limit to a stock’s share price. If a naked call seller must purchase the underlying stock and then deliver it at the strike price, there is no limit to the potential losses. Of course, in reality stock prices don’t increase to infinity, so this risk is purely hypothetical. However, there is still no specified limit on how much you could potentially lose on the trade.

In this example, if you had to deliver shares to sell at $60, but were forced to purchase at some unknown higher price, your effective losses would be the difference between what you had to purchase the stock at, and the strike price of $60. What if the underlying stock is acquired in a megamerger for $100? What about $200? At $200, we’re talking about losing $140 per share on 100 shares, or a $14,000 loss for a single options contract, which wouldn’t be offset by the $400 premium received.

However unlikely these scenarios might be in reality, they’re still theoretically possible.

Maximum gain: net credit

For a naked call position, the investor sells a call option and receives a premium upfront. The goal of the trade is for the option to expire worthless, in which case the investor keeps the entire premium.

In this example, the $4 premium is the max gain.

Breakeven: strike price plus premium

The breakeven on a naked call is simply the strike price plus the premium. If the stock closes upon expiration at that price, then the losses associated with the trade will exactly offset the upfront premium received.

In this example, if the stock closed at $64, then the $4 in premium received upfront would cover the $4 in losses (buying at $64 and selling at $60).

Margin requirements

Considering the theoretically unlimited risk that you and your broker/dealer are exposed to, the margin requirements for naked calls are extremely high in order to maintain the position. Broker/dealers are able to implement margin requirements that are stricter than regulations, which will vary between broker/dealers. Check with your broker/dealer for specific requirements.

From a regulatory standpoint, Reg T requires:

  • Naked in-the-money call: 100% of the option market value plus 20% of the underlying equity price.
  • Naked out-of-the-money call: The greater of a) 100% of the option market value plus 10% of the underlying equity price, or b) 100% of the option market value plus 20% of the underlying equity price minus 100% of the out-of-the-money amount.

A potentially better way

Naked calls often prove to be more trouble than they’re worth, in terms of risk exposure and margin requirement calculations. An alternative would be to create a wide bear call spread. You could choose to structure the spread wide enough that the premium received (net credit) would be comparable, while limiting risk and margin requirements by buying a long out-of-the-money call at a higher strike price.

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