Out-Of-The-Money Naked Call Explained

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Short Call

AKA Naked Call; Uncovered Call

The Strategy

Selling the call obligates you to sell stock at strike price A if the option is assigned.

When running this strategy, you want the call you sell to expire worthless. That’s why most investors sell out-of-the-money options.

This strategy has a low profit potential if the stock remains below strike A at expiration, but unlimited potential risk if the stock goes up. The reason some traders run this strategy is that there is a high probability for success when selling very out-of-the-money options. If the market moves against you, then you must have a stop-loss plan in place. Keep a watchful eye on this strategy as it unfolds.

Options Guy’s Tips

You may wish to consider ensuring that strike A is around one standard deviation out-of-the-money at initiation. That will increase your probability of success. However, the higher the strike price, the lower the premium received from this strategy.

Some investors may wish to run this strategy using index options rather than options on individual stocks. That’s because historically, indexes have not been as volatile as individual stocks. Fluctuations in an index’s component stock prices tend to cancel one another out, lessening the volatility of the index as a whole.

The Setup

  • Sell a call, strike price A
  • Generally, the stock price will be below strike A

Who Should Run It

NOTE: Uncovered short calls (selling a call on a stock you don’t own) is only suited for the most advanced option traders. It is not a strategy for the faint of heart.

When to Run It

You’re bearish to neutral.

Break-even at Expiration

Strike A plus the premium received for the call.

The Sweet Spot

There’s a large sweet spot. As long as the stock price is at or below strike A at expiration, you make your maximum profit. That’s why this strategy is enticing to some traders.

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Maximum Potential Profit

Potential profit is limited to the premium received for selling the call.

If the stock keeps rising above strike A, you keep losing money.

Maximum Potential Loss

Risk is theoretically unlimited. If the stock keeps rising, you keep losing money. You may lose some hair as well. So hold onto your hat and stick to your stop-loss if the trade doesn’t go your way.

Ally Invest Margin Requirement

Margin requirement is the greater of the following:

  • 25% of the underlying security value minus the out-of-the-money amount (if any), plus the premium received
  • OR 10% of the underlying security value plus the premium received

NOTE: The premium received from establishing the short call may be applied to the initial margin requirement.

After this position is established, an ongoing maintenance margin requirement may apply. That means depending on how the underlying performs, an increase (or decrease) in the required margin is possible. Keep in mind this requirement is subject to change and is on a per-contract basis. So don’t forget to multiply by the total number of contracts when you’re doing the math.

As Time Goes By

For this strategy, time decay is your friend. You want the price of the option you sold to approach zero. That means if you choose to close your position prior to expiration, it will be less expensive to buy it back.

Implied Volatility

After the strategy is established, you want implied volatility to decrease. That will decrease the price of the option you sold, so if you choose to close your position prior to expiration it will be less expensive to do so.

Check your strategy with Ally Invest tools

  • Use the Profit + Loss Calculator to establish break-even points, evaluate how your strategy might change as expiration approaches, and analyze the Option Greeks.
  • Use the Probability Calculator to verify that the call you sell is about one standard deviation out-of-the-money.
  • Use the Technical Analysis Tool to look for bearish indicators.

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Short Call (Naked Call) Options Trading Strategy Explained

Published on Wednesday, April 18, 2020 | Modified on Wednesday, June 5, 2020

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Short Call (Naked Call) Options Strategy

Strategy Level Advance
Instruments Traded Call
Number of Positions 1
Market View Bearish
Risk Profile Unlimited
Reward Profile Limited
Breakeven Point Strike Price of Short Call + Premium Received

Short Call (or Naked Call) strategy involves the selling of the Call Options (or writing call option). In this strategy, a trader is Very Bearish in his market view and expects the price of the underlying asset to go down in near future. This strategy is highly risky with potential for unlimited losses and is generally preferred by experienced traders.

The strategy involves taking a single position of selling a Call Option of any type i.e. ITM or OTM. These naked calls are also known as Out-Of-The-Money Naked Call and In-The-Money Naked Call based on the type you choose. This strategy has limited rewards (max profit is premium received) and unlimited loss potential. When the trader goes short on call, the trader sells a call option and earn profits if the price of the underlying asset goes down. The trader receives the premium when he sells the call option. This premium is the maximum profit trader gets in case the price of underlying asset falls.

Let’s assume you are bearish on NIFTY and expects its price to fall. You can deploy a Short Call strategy by selling the Call Option of NIFTY. If the price of NIFTY shares falls, the call option will not be exercised by the buyer and you can retain the premium received. However, if the price of NIFTY rises, you will start losing money significantly and rapidly on every rise.

This strategy has unlimited risk and limited rewards.

How to use the short call options strategy?

The short call strategy looks like as below for NIFTY which is currently traded at в‚№10400 (NIFTY Spot Price):

ITM Naked Call Order – NIFTY

Orders NIFTY Strike Price
Sell 1 ITM Call NIFTY18APR10200CE

Suppose NIFTY shares are trading at 10400. If we are expecting the price of NIFTY to go down in near future, we sell 1 NIFTY Call Option to implement this strategy.

If NIFTY falls as we expected, the call options will not be exercised by buyer and we will keep the premium received at the time of selling the call option. This is also the maximum profit in this strategy.

If NIFTY rises, the losses are unlimited. This makes it extremely risky strategy. This strategy should be used very carefully with bracket orders (stop loss).

When to use Short Call (Naked Call) strategy?

It is an aggressive strategy and involves huge risks. It should be used only in case where trader is certain about the bearish market view on the underlying.

Example

Example 1 – Stock Options (OTM Naked Call)

Let’s take a simple example of a stock trading at в‚№48 (spot price) in June. The option contracts for this stock are available at the premium of:

Lot size: 100 shares in 1 lot

  1. Sell July 50 Call = 100 * 3 = в‚№300 Premium Received

Net Credit: в‚№300

Now let’s discuss the possible scenarios:

Scenario 1: Stock price remains unchanged at в‚№48

  • Sell July 50 Call: Expires Worthless
  • Net credit was в‚№300 which was received as premium initally.
  • Total profit = в‚№300 as we keep the premium.

The total profit of в‚№300 is also the maximum profit in this strategy. This is the amount you received as premium at the time you enter in the trade.

Scenario 2: Stock price goes up to в‚№68

  • Sell July 50 Call expires in-the-money with an intrinsic value of (50-68)*100 = -в‚№1800
  • Net credit was в‚№300 which was received as net premium.
  • Total Loss = -1800 + 300 (Premium Received) = -в‚№1500

In this scenario, we lost total в‚№1500. The loss could be significantly higher if the price of the stock keeps rising further.

Scenario 3: Stock price goes down to в‚№28

Same as scenario 1:

  • Sell July 50 Call: Expires Worthless
  • Net credit was в‚№300 which was received as premium initally.
  • Total proft = в‚№300 as we keep the premium.

Example 2 – Bank Nifty

Short Call Example Bank Nifty
Bank Nifty Spot Price 8900
Bank Nifty Lot Size 25
Short Call Options Strategy
Strike Price(в‚№) Premium(в‚№) Total Premium Paid(в‚№)
(Premium * lot size 25)
Sell 1 ITM Call 8800 500 12500
Net Premium 500 12500
Breakeven(в‚№) Strike price of the Short Call + Net Premium
(8800 + 500)
9300
Maximum Possible Loss (в‚№) Unlimited Unlimited
Maximum Possible Profit (в‚№) Net Premium Received * Lot Size
(500)*25
12500
On Expiry Bank NIFTY closes at Net Payoff from 1 ITM Call Sold (в‚№) @8800 Net Payoff (в‚№)
8800 0
(8800-8800)*25
12500
12500-0
9000 -5000
(8800-9000)*25
7500
12500-5000
9200 -10000
(8800-9200)*25
2500
12500-10000
9400 -15000
(8800-9400)*25
-2500
12500-15000
9600 -20000
(8800-9600)*25
-7500
12500-20000

Market View – Bearish

When you are expecting the price of the underlying or its volatility to only moderately increase.

Actions

  • Sell Call Option

Breakeven Point

Strike Price of Short Call + Premium Received

Break even is achieved when the price of the underlying is equal to total of strike price and premium received.

Risk Profile of Short Call (Naked Call)

Unlimited

There risk is unlimited and depend on how high the price of the underlying moves.

Reward Profile of Short Call (Naked Call)

Limited

The profit is limited to the premium received.

Options Trading: Covered Put v Naked Call: Which is better?

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Covered calls and naked puts are “similar” with a slight edge going to naked puts in my opinion. Naked puts because no interest costs on margin and more than 2x leverage on some stocks.

With covered puts you need an understanding of short-selling stock. With covered puts you sell put options on stocks you have shorted, that’s how you are “covered” in the trade.

With covered calls you sell call options on stocks you own and that is how you are “covered” in that trade.

Naked calls is in a category all by itself. You need minimum amounts of cash in your account despite what it would cost .

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