Definition: Naked Call
An options strategy in which the call options are sold in the open market and the seller does not own the underlying asset is known as a naked call. This options strategy is also known as an unhedged short call and uncovered call, which is the complete opposite of the covered call strategy in which the investor sells the call option and holds the underlying asset as well.Summary
Writing a naked call stands for the selling of a call option contract and not holding the underlying asset on which the call option is written. Selling the call option is termed as being ‘short’ in the call options, that is, the investor is giving the buyer the option to buy the underlying asset from him/ her on a future date at a predetermined price. On other hand, being long in the call option stands for getting the right to buy the underlying asset at a predetermined price on a future date.
The position of the investor who is short in the option is said to be covered when they have ownership of the asset and uncovered when they do not have ownership of the asset.
A higher amount of risk is involved in the naked call and therefore it is tagged as the advanced level of trading. Generally, brokers do not allow to take the naked call position in the market until the investors meet certain criteria such as large margin account and considerable experience in the stock market.
“Sell to open” a call position is terminology that is used while instructing the broker to sell the naked call. The investor who has taken the naked call position is forced to buy the underlying security at the current market price and sell the same at the strike price, in case the call option buyer exercises their right to buy.
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There is a difference between the long a put and the short a call option. The difference exists because of the premium paid or received and the risk exposure.
In the short call, the investor receives the premium amount for selling the right to buy and is exposed to greater risks that arise when the call options go in the money.
In the long put, the investor pays the premium amount and the only risk he/she is exposed to is the loss of the premium amount.
In the naked call, the maximum loss which the investor must bear is unlimited as there is no upper-bound limit to the prices of the share. In case the call option is exercised by the buyer, then the seller must buy the underlying asset and sell the same to the option holder at the strike price, therefore there is no limit on the loss amount. A stock price does not reach infinity in a practical environment; however, the risk cannot be defined.
For instance, an investor invests in a naked call strategy that has a strike price of $100 for 100 shares. In case the prices of the underlying asset reach $50, then the buyer of the call potion will not exercise the option and the investor will make a profit worth the premium amount.
On other hand, in case the stock price reaches $150, and the buyer exercise the option, then the investor must buy the underlying asset at $150 from the market and sell the same to the option buyer at $100. In this scenario, the investor faces a loss of $50 per share (subtract the premium amount received by the investor). The loss will intensify with the increase in the current market price.
Suppose the price reaches $100, then the loss will reach $100 per share. These situations do not occur in the practical environment, however, theoretically, the risk is unlimited.
In the naked call, the maximum profit a person can make is net credit. In exchange for selling the call option, the investor receives the premium amount. The motive of the investor while opting for the naked call strategy is that the call option becomes worthless, and an investor can earn the premium amount.
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Those investors should enter a naked call who strongly believe that the share prices will fall or stay constant till the expiration of the call option. In a naked call, the income is generated through the premium amount. If the prices of the underlying assets fall below the strike price, then the option writer earns a premium minus the commission.
The risks in the naked call are immense, therefore only experienced investors enter this position.
Theoretically, the naked call is exposed to an unlimited amount of risk, therefore, it is essential to maintain a high amount of margin in the investor’s account to maintain the position. The margin requirements are dependent upon the brokers, and generally, they are stricter than regulations.
While closing the naked call option, the investor must assess whether the call option is in the money or out of the money. In case the call option is out of money then the option can be bought back at cheaper prices. On other hand, if the option is in the money, then the option can be bought at a higher price of the option can be closed by buying the underlying asset.