What it means
A call option gives the buyer the right to buy shares at a fixed price, called the strike price, before a set date. The seller, also called the writer, is obliged to hand over those shares if the buyer exercises.
If the writer already owns the shares the call is covered, and if not it is naked, also called uncovered. The writer's best outcome is that the option expires worthless, so the premium becomes pure profit.
That is the maximum gain and it is small and fixed. The trade-off is that if the share price shoots up, the writer must buy shares at the market price to deliver them at the lower strike price.
Because a share price can in theory keep rising, the potential loss has no limit. A takeover bid, a surprise earnings result or a short squeeze can move a price far beyond the strike in a single day.
This asymmetry between a small, capped gain and a large, open-ended loss is the main reason the strategy is considered dangerous. Brokers therefore require the writer to keep margin, which is cash or securities held as a safety buffer against losses.
The required margin can rise when the share price rises, and failure to meet a margin call can lead to the broker closing the position at a loss. Traders use naked calls to earn income when they believe a share will stay flat or fall.
Most finance teams, treasurers and corporate managers should never sell them, and many company policies forbid it.
In practice
Real-world examples.
Example
A private investor believes a mature utility company will trade sideways, so she sells a naked call for a $150 premium. The share unexpectedly jumps 12% after a regulatory announcement, and she loses several times the premium.
Example
A hedge fund sells uncovered calls on a retailer ahead of earnings, expecting a flat result. The retailer announces a takeover offer, the price leaps, and the fund must buy shares at the higher price to deliver them.
Example
A technology company executive wants to earn extra income on shares he does not own but wants to trade options. His employer's compliance team refuses to allow naked calls on any security, to avoid both risk and conflicts of interest.
Formula
Calculation
Breakeven price = Strike price + Premium per share
Profit or loss at expiry = Premium received - the greater of (Share price - Strike price) and zero, all multiplied by the number of shares
One standard US contract covers 100 shares. Suppose a trader sells one call with a strike price of $50 and receives a premium of $2 per share, so $2 x 100 = $200 in total. The breakeven price is $50 + $2 = $52.
If the share finishes at $48, the option expires worthless and the trader keeps the full $200. If the share finishes at $58, the option is worth $58 - $50 = $8 per share, so the loss is ($8 - $2) x 100 = $600. If the share finishes at $70, the loss is ($20 - $2) x 100 = $1,800, and it keeps growing as the price rises.Case study
Seen in the real world.
Redstone Capital is an illustrative, fictional private trading firm that earned steady monthly income by writing naked calls on shares it considered unlikely to rise. For two years the strategy produced premiums of around $40,000 a month with almost no losses.
In the third year, a small drug developer in the portfolio announced a clinical trial success. The share price tripled overnight, and Redstone faced a loss of more than $900,000 against just $40,000 of premium collected.
In this illustrative story the firm survived, but only because it had set a tight position limit. The lesson is that many small premiums can be wiped out by a single event when losses are unlimited.
Watch out
Common mistakes.
- Treating the premium as the maximum risk, when the potential loss on a naked call is open-ended.
- Ignoring margin calls, which can force the position to close at the worst moment.
- Selling naked calls on a heavily shorted or takeover-rumoured share, where sudden price jumps are most likely.
Questions
People also ask.
What is the opposite of a naked call?
A covered call, where the seller owns the underlying shares and so can deliver them if the option is exercised.
Can a company sell naked calls?
A company can only do so if its board policy, auditors and regulators allow it, and most corporate treasury policies forbid it because of the unlimited risk.
Why would anyone sell a naked call?
To earn premium income when they expect the share to stay flat or fall, accepting the risk of large losses in return.
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