Selling a call is a common strategy in options trading, and there are many ways to do it. Naked call options involve selling the call without holding the underlying asset, a move that promises profits but comes with significant risks, as this naked call strategy exposes the seller of the option to unlimited losses. This article explains what a naked call option is and how selecting calls with high implied volatility and a distant breakeven can play to your advantage. So, let’s see everything you need to know to sell a call option on the market.
Key takeaways
- Naked call options are a risky options strategy where the investor writes call options without owning the underlying security. Naked call options expose traders to potentially unlimited losses, while the potential profit is limited to the premium received.
- Selecting high-IV naked call options with a distant breakeven point in terms of ATR can increase the likelihood of success of your trade.
- Selecting high-IV naked call options with a distant breakeven point in terms of ATR can increase the likelihood of the option expiring worthless and boost the success of your naked call strategy.
What is a Naked Call Option?
A naked call option involves a seller offering call options on the market without owning the corresponding underlying asset. This naked option strategy is used by investors who anticipate that the value of the underlying security will decline or remain stagnant.
Conversely, a naked put involves selling a put option without owning cash reserves to buy the stock, betting the price will rise or stay flat (however, this article will only focus on naked calls).
By selling naked call options, traders can receive (and keep) the option premium as profit without actually owning the security itself, but the risk of a margin call increases with significant price moves. This is something you should never forget before selling naked calls.
Selling Naked Options – A Focus on Using Naked Calls
It’s important to understand that naked call options are a strategy with a sideways or bearish outlook. When selling naked calls, you are betting that the stock price will not rise significantly.
If the stock price increases, your potential loss is theoretically unlimited, as there is no cap on how high the strike price of the option can go if the option buyer exercises their rights.
This makes selling naked options one of the riskiest strategies, as losses can compound if the stock keeps moving against you, requiring the seller of the naked call to potentially buy back the option at a higher price. For example, if a stock is priced at $100 and rises by 10%, you lose $10. If it rises another 10%, you lose $11, and so on.
Despite the risks, some traders are attracted to selling uncovered calls because it is a high-probability strategy, allowing the option seller to profit from the premium received for these speculative trades.
The immediate income generated from the premiums received for selling naked call options can be particularly attractive, especially in high-volatility scenarios where the likelihood of the option expiring worthless is higher.
High implied volatility generally means higher premiums and potentially overbought options, which can provide a profitable opportunity for traders using naked call options.
However, it is crucial to be aware that selling naked options can provide steady income, but the losses can be substantial when the market moves against your expectations. The key takeaway is that while trading naked calls can be profitable, this speculative options strategy requires careful risk management and a strong understanding of the risks involved, especially for the naked call writer.
An Example of Naked Call Options
An example will certainly help clarify the mechanics of trading with naked call options. Imagine you come across an appealing trade using our advanced options scanner (we’ll tell you more about how you could find this trading idea and others later).
You identify an opportunity to write a naked call option by selling an out-of-the-money (OTM) call on CRSP, a speculative options strategy aiming to profit from time decay. Suppose that your thorough research indicates its financial fundamentals and growth prospects are not up to par with market standards.
According to our options screener, when selling naked calls in this way, there’s a chance to sell a $61 call expiring in 10 days. With CRSP’s current trading price at $53.25, your strategy requires the stock’s price to remain below $61.90 by the call’s expiration to give you a profit. Here is what your P&L profile would look like:
Upon reviewing CRSP’s stock chart, it’s evident that the stock has been experiencing a downtrend for several weeks. The breakeven price, which is the threshold above which losses begin, appears comfortably distant, especially for a call expiring in just 10 days.
The stock bearish trend may be close to an end, but, with no major events coming for this company, it seems unlikely that the stock will rapidly rise above the option strike price of $61.90, reducing the risk associated with naked call options. Therefore, we may obtain a $100 return at a rather high probability, and you may think that selling naked options (in this specific case, call options) in this way may be a good trade idea.
Analyzing This Naked Short Call Trade
The objective here is to allow the time value to diminish the option’s worth, aligning with your goal as a short seller to see the option’s price drop closer to zero, maximizing your earnings.
If your analysis holds true, the reward is the option premium of $90 received for selling the call option, representing the maximum profit in this short call position. This gain reflects the direct income from the premium, your ultimate goal when selling naked calls. Nevertheless, the risk of potentially unlimited losses if the market moves against your prediction is something you cannot ignore.
This example shows the typical trade-off in trading naked call options: substantial capital is at risk, yet the likelihood of the option expiring worthless remains relatively high if the trade was selected with care.
More details on selling uncovered calls effectively will follow, as we provide the ultimate, most detailed screener to assist you in finding great opportunities.
Selling Naked Calls: Pros and Cons
After seeing the example above, we can summarize the pros and cons of naked call options below:
| Pros of Selling Uncovered Calls | Cons of Selling Uncovered Calls |
| Immediate premium income | Unlimited potential losses |
| Short market without short selling | Limited profit potential |
| Flexible trading strategy | High margin requirements |
| Time works in your favor | Not suitable for beginners |
Pros of Naked Call Options
- Generates immediate premium income: Sellers receive upfront payments, offering an instant cash flow from their trading activities.
- A way to short the market without selling short the underlying: Allows traders to speculate on a security’s decline without the need to borrow and sell the stock.
- Flexibility in trading strategy: Traders can use naked calls as part of a broader trading plan, adjusting their positions based on market movements and predictions.
- Time is in your favor: Even if the stock price rises a little bit, time decay will erode the value of the call you sold as long as the underlying price remains below the breakeven level.
Cons of Naked Call Options
- Unlimited potential losses: If the market moves unfavorably, losses can exceed the initial premium received, potentially by a substantial margin. Note that the loss here is compounded, which means that a higher price will correspond to an even higher margin as losses continue to increase.
- Limited profit potential: The maximum gain is capped at the premium received, regardless of how much the market moves in the seller’s favor.
- High margin requirements from brokers: To cover potential losses in selling naked options, brokers often require significant cash or collateral upfront, as a margin call may occur if the price of the option increases sharply.
- Not suitable for beginners: The complex nature and high risk of selling naked calls make it an inappropriate strategy for novice traders.
How to Manage Your Risk with Naked Calls
Before leaving you, we promised to give you more details about how to use our screener to select the prime opportunities for naked call options.
For instance, you can use fundamental data to spotlight companies that are underperforming financially. This analysis is critical for identifying potential naked call options where the risk/reward balance is in your favor.
Understanding Naked Calls and Their Risk with the “Scenario” Feature
On our screener, you can leverage the “scenario” feature, which forecasts your profit or loss based on the stock’s movement by one standard deviation. This predictive tool helps you assess the potential outcomes of your naked call or put option trades, letting you see ahead what may happen to your trade if the stock drops or if it climbs.
Integrating these features into our scanner results in a powerful tool that sifts through the noise to identify the best opportunities for selling uncovered calls, even in volatile markets.
Additionally, we have an alert feature that keeps you informed about significant stock movements — for instance, if a stock surges by 5% in a day, it suggests the best short-call options available (assuming the stock is overbought).
The example we referenced earlier wasn’t picked out of thin air. It was carefully selected based on a thorough fundamental analysis, identifying a company with a low fundamental score, opting for calls with high implied volatility (signaling they might be overpriced), and choosing those with a breakeven point significantly far away. For more info, you can look at the image below:
You can see that we have a low “Stock Score” value (the first number is the fundamental feature, the second assesses the company’s growth, and the third is the technical score), a high IV rank (we’re above 80%, meaning that, in 80% of the days during the past year, the company’s options had a lower IV compared to the current one), and the breakeven point that would put you in trouble is really far away (2.85 ATRs). This trick can be a big helper when selling naked options.
Frequently Asked Questions About Using Naked Calls
What is a naked call option?
A naked call option is a short call where the option writer does not own the underlying stock. This call strategy profits from premium income if the option expires worthless or remains below the strike price.
How risky is an uncovered call option?
Uncovered calls carry unlimited risk since the underlying stock price can rise indefinitely. Option sellers must carefully manage their short position to avoid significant losses when they write a naked call without owning the asset. This is something to keep in mind before selling uncovered calls.
How much can you lose on an uncovered call?
The potential loss on naked call options is unlimited, as the option writer may need to buy the underlying stock at any price if the call position exceeds the strike price when the option contract expires
