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Naked call writing is an outstanding strategy among several others in options trading. Unlike in covered call writing, where the seller has the underlying asset, naked call writers do not hold the asset itself but sell call options, hoping that the price will remain below the strike price.
In this article, we will dig into detail regarding how naked call writing works and the risks associated with it.
What is naked call writing?
Naked call writing refers to an options trading strategy where the writer of a call option (seller) does not own the underlying asset. Instead, the writer disposes of call options with the hope that the price of underlying assets will remain below the strike price at the time when the option expires.
If it remains below a particular strike level, the option expires, and the premium received from the buyer remains with the writer.
However, if it comes above this level, then writers risk unlimited losses as they have to buy back the stock at higher market prices, thus fulfilling their obligation.
Naked call writing strategy involves significant risks and should be carefully examined against prevailing market conditions and risk management strategies.
Example of Naked Call Writing
Let’s consider a scenario where Rahul, an options trader, believes that XYZ Company’s stock, currently trading at ₹500 per share, is overvalued and will decline in the near term. Without owning any shares of XYZ, Rahul decides to employ a naked call writing strategy.
Rahul sells one naked call option contract for XYZ with a strike price of ₹520 and an expiration date one month away. He receives a premium of ₹20 per share, totalling ₹2,000 for the entire contract.
If the stock price remains below ₹520 at expiration, the call option expires worthless, and Rahul keeps the entire premium as profit. However, if the stock price rises above ₹520, Rahul faces unlimited losses as he must buy the shares at the market price to fulfill the call option contract.
This example illustrates the potential profit and risk involved in naked call writing, emphasizing the importance of careful analysis and risk management in options trading.
Advantages of Naked Call Writing
Writing naked calls is one of the strategies that can provide huge financial benefits to the trader; however, it is also associated with substantial risks. Nevertheless, there are several advantages of writing naked calls:
1. Profit potential
Naked call writing generates income by selling call options without owning the underlying assets. Sellers receive premiums upfront, profiting if the underlying stock price remains below the strike price at expiration, rendering the options worthless.
This strategy offers immediate income without tying up capital in the underlying asset, making it appealing for traders seeking to monetize their market outlooks.
2. Time decay
Options contracts experience time decay, meaning their value decreases as the expiration date approaches, especially if the underlying asset’s price remains relatively stable.
Naked call writers can benefit from this phenomenon as time decay works in their favour, eroding the value of the call options they’ve sold.
3. No Requirement of Capital
Unlike covered call writing, which requires owning the underlying stock, naked call writing doesn’t tie up capital in the underlying asset.
This can be advantageous for traders who want to generate income without committing significant capital to the trade.
4. Bearish Outlook
Naked call writing suits traders with a bearish view. By selling call options, they profit if the stock price drops or remains below the strike price. This strategy enables them to capitalize on anticipated declines without owning the underlying stock.
However, it carries the risk of unlimited losses if the stock price rises significantly, requiring careful risk management.
Risks of Naked Call Writing
Naked call writing can be a good strategy for generating income, but it also has its own risks. The main disadvantages of naked call writing are:
1. Unlimited losses
One of the most significant risks of naked call writing is the potential for unlimited losses.
If the price of the underlying security rises significantly above the strike price of the call option, the seller may be forced to buy the stock at a much higher price to fulfil the option contract.
2. Limited profit potential
While the seller receives the premium from selling the call option, their potential profit is limited to this premium.
If the price of the underlying security rises sharply, the seller’s losses can far outweigh the premium received.
3. Margin Requirements
Brokers typically require sellers of naked call options to maintain a margin account due to the unlimited loss potential.
This means that the seller must have sufficient funds in their account to cover potential losses, which can tie up capital and increase the cost of the trade.
4. Assignment Risk
Sellers of naked call options are exposed to assignment risk, which occurs when the buyer of the option exercises their right to buy the underlying security.
If the option is assigned, the seller must sell the security at the strike price, potentially resulting in significant losses if the market price is higher.
Risk management measures in naked options writing
Experienced traders often seek ways to mitigate potential losses resulting from the unlimited upward movement of stock prices. Two common methods for achieving this are frequently employed:
Buying shares below strike price
Instead of immediately writing naked call options, a trader can consider buying shares of the same company when their price is lower than the strike price.
By doing so, the trader aims to ensure that the strike price of the call options is higher than their purchase price for the shares.
Buying a call option as a hedge
Alternatively, a trader can purchase a call option for the same company’s stock. This approach allows the trader to establish a fixed price at which they would be obligated to buy the stock if needed to fulfil their obligation under the call options contract.
Conclusion
Naked call writing is a strategy in options trading that can bring in profits but also carries considerable risks. Before jumping in, make sure you fully grasp how it works and the potential downsides. Always be cautious and keep learning. If you want to expand your knowledge further, subscribe to StockGro.
FAQs
Yes, it can be highly risky. Since there’s no limit to how high the price of the asset can go, your potential losses are unlimited. It’s essential to understand and manage these risks carefully.
In naked call writing, you don’t own the underlying asset, while in covered call writing, you do. Covered call writing provides a level of protection against potential losses, unlike naked call writing.
You can manage risk by setting strict stop-loss orders, diversifying your investments, and continuously monitoring the market.
Yes, investors often use hedging strategies like buying further out-of-the-money call options or selling put options to offset potential losses from naked call writing.
Yes, you profit if the market remains below the call option’s strike price until expiration. However, be cautious of potential losses if the market rises unexpectedly.