What Is a Naked Call Options Strategy, and How Does It Work?

What Is a Naked Call?

A naked call is a risky options strategy in which an investor writes (sells) call options on the open market without owning the underlying security. Many brokers, including Robinhood, forbid retail traders from trading naked calls, given the risk. However, Charles Schwab and others allow them when there's a certain minimum of funds in the account.

This strategy, also called an uncovered or unhedged short call, contrasts with the less risky covered call strategy, where the investor owns the underlying security on which the call options are written. The potential profit in this strategy is limited, but losses are theoretically limitless.

Understanding Naked Calls

Investors use naked call options to generate premium income without directly selling the underlying security. Essentially, the premium received is the sole motive for writing an uncovered call option.

It's inherently risky since there is limited upside potential and, in theory, unlimited downside losses. In fact, the maximum gain is the premium that the option writer receives upfront, which is usually credited to their account. So, the writer's goal is to have the option expire worthless.

The maximum loss is theoretically unlimited because there is no cap on how high the underlying security price can rise. In more practical terms, the seller of the options will likely repurchase them well before the price of the underlying rises too far above the strike price, based on their risk tolerance and stop-loss settings.

Therefore, the seller of call options wants the underlying security to fall so they can collect the entire premium if the option expires worthless. But if the underlying security price rises, they may have to sell the stock at a price far below the market price. This happens when the option buyer exercises their right to buy the security.

Using Naked Calls

Again, there is a significant risk of losses with writing uncovered calls. However, investors who are confident that the expected price of an underlying security, usually a stock, will fall or stay the same can write call options to earn the premium. If the stock stays below the strike price between the time the options are written and their expiration date, then the writer of the option keeps the entire premium minus commissions.

However, if the stock price rises above the strike price by the option expiration date, the buyer of the options can demand the seller deliver shares of the underlying stock. The options seller will then have to go into the open market and buy those shares at market price to sell them to the buyer of the option at the option strike price.

If, for example, the strike price is $60 and the open market price for the stock is $65 at the time the options contract is exercised, the options seller will incur a loss of $5 per share of stock less the premium received.

Naked Options and Risk

The writer's breakeven point is calculated by adding the option premium received to the strike price of the sold call. Any rise in implied volatility is a problem for the writer since the probability of the option being in the money and thus being exercised also increases. Since the option writer wants the naked call to expire out of the money, the passage of time, or time decay, is a positive outcome for this strategy.

Due to the risk involved, only experienced investors who are highly confident that the underlying security price will fall or remain flat should use this sophisticated strategy. The margin requirements are often very high for this strategy because of the possibility of open-ended losses, and the investor may be forced to purchase shares on the open market before expiration if the margin threshold is crossed.

The upside to the strategy is that investors could receive income through premiums without putting up much initial capital.

Managing Risk for Naked Calls

Risk management strategies can help mitigate losses, but naked call writing remains high risk even with many of these and other methods and is therefore not suitable for most investors. Understanding the risks involved thoroughly and having a solid grasp of options trading before writing naked calls is crucial. When doing so, here are some strategies for mitigating potential losses:

Covered calls: Obviously, the first way to mitigate risk is not to write naked calls in the first place. In this strategy, you own the underlying stock and sell call options against those shares. This limits your upside potential and reduces your risk, as you already own the shares you may be obligated to sell if the trade goes against you.

Diversification: Spread your naked call positions across underlying securities, sectors, and expiration dates. This can help reduce the impact of any position that moves against you.

Fund your account well: Ensure you have sufficient capital to cover potential losses and meet margin requirements. Don't overleverage your account.

Position sizing: Limit the size of your naked call positions relative to your overall portfolio. This helps to ensure that a single trade doesn't have an outsized impact on your portfolio.

Spreads: Use option spreads to limit risk. For example, a call credit spread involves selling a call option and simultaneously buying another call option with a higher strike price. This caps your maximum loss at the difference between the two strike prices minus the net premium received.

Stop-loss orders: As with other derivative trading, these are your best risk management tools. Place stop-loss orders to automatically close out your position if the underlying security's price reaches a preset threshold. This would limit your losses if the market moves against you.

Advantages and Disadvantages of Naked Call Options

Despite the risks, an appealing feature of naked call options is the ability to earn premium income without owning or shorting the underlying security. The premium collected upfront is the primary source of profit in this strategy, credited to the investor's account immediately upon selling the call option. For those good at forecasting market moves, this strategy can be lucrative. Of course, it can be a disaster for those who aren't.

As such, the risks and downsides of the naked call strategy are considerable and warrant careful consideration. The most glaring issue is the strategy's inherent risk profile, which includes limited profit potential (strictly capped at the premium received) against theoretically unlimited losses if the underlying asset rises above the call's strike price. This imbalance stems from the fact that there is no upper limit to how high the underlying asset price can climb. If the market moves contrary to the investor's expectations, the costs to buy back the option or cover the position in the market can be exorbitant, leading to significant losses.

The need for high margin deposits when doing these trades comes from this high level of risk, safeguarding the brokers involved. In addition, even if the underlying falls somewhat, an increase in implied volatility can work against the seller, raising the likelihood of the option ending in the money and being exercised, magnifying the risk of loss. Given these considerations, the naked call strategy is best reserved for seasoned investors with a high risk tolerance and a well-calibrated approach to managing potential losses.

Example

Le's use a scenario involving Tesla, Inc. (TSLA), known for its volatility and significant price moves. In early 2024, Tesla's stock was trading at about $200 per share. Several investors pool their money and believe that Tesla's stock price will fall or remain at about that price in the short term. They write a naked call option with a strike price of $300, expiring in January 2025. The investors get a premium of $30 per option.

If Tesla's stock price remains below $300 by the expiration date, the call options will expire worthless, and the investor gets to keep the $30 premium. However, let's imagine Tesla announces some groundbreaking technology or significantly better-than-expected earnings, causing the stock to surge to $400 by the end of the year. In that case, the investor would be obligated to sell Tesla shares at the strike price of $300 or a loss of $100 per share, minus the $30 premium received, resulting in a net loss of $70 per share.

This example highlights the income-generating potential and the significant risks of naked call options, emphasizing why it's one of the riskiest options strategies.

The Bottom Line

A naked or uncovered call is when you sell a call option without owning the underlying security or some equivalent. The seller (writer) of the call gets immediate premium income from the option's buyer and will collect the full amount if the option expires out of the money. However, if the underlying rises above the strike price, there's the potential for unlimited losses. This makes it a very high-risk strategy suitable only for certain investors or traders.