What is a naked call?

What is a naked call?

A naked call is a type of option contract where the seller of a call does not own the underlying security, thereby exposing them to unlimited risk. Investors have the ability to “write” or sell options contracts as well as to buy them.

The seller of a call option has opened a position in which the buyer is given the right to buy 100 shares of a stock at the strike price named in the contract. The seller – along with all other sellers of calls for that security – are the ones who must cover and close the open positions if the call owners exercise their options.

They would be likely to do this if the price of the underlying security became higher than the strike price of the option. Such an obligation might fall to them by random assignment or through a direct obligation to the person that bought the option that was written and sold. A call is naked if the seller of the call does not possess the underlying asset.

For example, let’s say you sold a Naked Call (for $5/share) for company ABC (which is trading now at $100/share) with a strike price of $110 and a duration of three months. If three months later, the stock is trading under $110/share, the premium you received is yours to keep and your obligation expires.

If, however, your stock is trading at $200/share, you’re in trouble, because you have the obligation to deliver the stock which you don’t have, and you have to buy it on the open market at $200/share. After you buy the stock for $200 per share, you will only be paid $110 for it by the owner of the call contract.

Your loss would be $200 - $110 – $5 premium = $85 per share in that case, and considering each options contract is for 100 shares, that adds up to $8,500. And what if the stock price had risen even higher? The losses on Naked Calls are potentially unlimited, theoretically. Naked calls tend to be forbidden by brokerage houses for this reason.