Naked Calls
Risk: high
Reward: limited
General Description
Entering a naked call position entails selling calls.
The Thinking
This strategy is employed when you are very bearish. If the stock closes below the strike price on expiration day, you keep the entire premium. But if the stock rallies, you have unlimited loss potential to the upside because by selling calls you are granting someone else the right to “call” the stock from you at a predetermined price (the strike price). So if the stock rallies and the option buyer exercises the call, you will be forced to buy the stock in the open market at a high price and then immediately turn around and sell the stock at the lower strike price. Obviously naked calls carry very high risk, and most traders will not be approved by their broker to enter such a position.
Example
Let's say IBM is trading @ 83.10. You sell the 90 calls for $1.35.
If the stock closes below 90 on expiration day you keep the entire premium and your max profit scenario will be realized. A stock price between 90.0 and 91.35 (90.0 + 1.35) will get you some, but not all of your money back. Above 91.35, your loss grows as the stock moves up.
The image below summarizes the trade with a P/L Diagram. |
