Managing Naked Call Options: Risks and Strategies

Managing Naked Call Options: Risks and Strategies

Selling a call is a common strategy in options trading, and there are many ways to do it. Naked call options involve selling calls without holding the underlying asset, a move that promises profits but comes with significant risks. This article breaks down how selecting calls with high implied volatility and a distant breakeven can play to your advantage. Plus, we will show you how we offer an advanced scanning environment that aids in identifying optimal opportunities for selling naked options.

Key takeaways
  • Naked call options are a risky options strategy where the investor writes call options without owning the underlying security. The potential profit in this strategy is limited, but losses are theoretically unlimited.
  • Selecting high-IV naked call options with a distant breakeven point in terms of ATR can increase the likelihood of success of your trade.
  • Option Samurai offers one of the most advanced scan environments for naked call options, with both fundamental, technical, and option-related filters.

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 strategy is used by investors who anticipate that the value of the underlying security will decline or remain stagnant. By selling naked calls, they can receive (and keep) the premium income as profit without actually owning the security itself.

It’s important to understand that a naked call is a strategy with a sideways or bearish outlook. When you sell a naked call, 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 stock price can go. This makes naked calls highly risky, as losses can compound if the stock keeps moving against you. 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 naked calls because it is a high-probability strategy. This means that although individual wins may be smaller, they are more frequent. The immediate income generated from the premiums received can be particularly attractive, especially in high-volatility scenarios where premiums are naturally higher. High implied volatility generally means higher premiums and potentially overbought options, which can provide a profitable opportunity for sellers.

However, it is crucial to be aware that while this strategy can provide steady income, the losses can be substantial when the market moves against your expectations. The key takeaway is that while selling naked calls can be profitable, it requires careful risk management and a strong understanding of market conditions.

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 sell an out-of-the-money (OTM) call on CRSP. Suppose that your thorough research indicates its financial fundamentals and growth prospects are not up to par with market standards. According to the options screener, 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:

naked call strategy

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.

naked call stock

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 $61.90. Therefore, we may obtain a $100 return at a rather high probability.

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.

In this scenario, if your analysis holds true, the reward is the call premium of $90. 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 involved in these operations: substantial capital is at risk, yet the likelihood of incurring losses remains relatively low, provided the trade was selected with care.

More details on utilizing naked call options scanning strategies effectively will follow, as we provide the ultimate, most detailed screener to assist you in finding great naked call 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 cons naked call

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, brokers often require significant cash or collateral up front.
  • 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. We believe that Option Samurai is a great screener to help you sell options, and we’re not just saying this, we can show you.

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.

With Option Samurai, 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 is very powerful for assessing the potential outcomes of your naked call trades, letting you see ahead what profits you might pocket if the stock drops, or conversely, assess the losses if it climbs.

Integrating these features into our scanner results in a powerful tool that sifts through the noise to find you the best opportunities for selling uncovered calls. 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:

naked call scan

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 strategic approach, backed by robust tools like Option Samurai, gives you everything needed to manage your risks effectively when engaging in naked calls.

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