Options trading is a popular method of investing in the stock market. One type of option that is commonly used is a naked call option. While this concept can be a bit confusing, it is important to understand how it works and the risks involved before deciding whether or not to use this strategy. In this article, we will explain what a naked call option is, how it works, and provide some examples to help you better understand this concept.
What is a Naked Call Option?
A naked call option is a type of options contract where the seller, also known as the writer, sells a call option without owning the underlying asset. In simpler terms, the seller is betting that the price of the underlying asset will not rise above the strike price before the expiration date of the contract. If the price of the underlying asset does not rise above the strike price, the seller keeps the premium that the buyer paid for the option. However, if the price of the underlying asset rises above the strike price, the seller could potentially face unlimited losses.
How Does a Naked Call Option Work?
To better understand how a naked call option works, let’s consider an example. Imagine that Jane owns 100 shares of XYZ Company, which is currently trading at $50 per share. She decides to sell a naked call option with a strike price of $55 and an expiration date of one month from now. The buyer of the call option pays Jane a premium of $2 per share, or $200 in total, for the option.
If the price of XYZ Company’s stock does not rise above $55 before the expiration date, Jane keeps the $200 premium and the option expires worthless. However, if the price of the stock does rise above $55, the buyer of the call option can exercise their right to buy the stock from Jane at the strike price of $55 per share. If the stock price rises to $60 per share, for example, Jane would have to sell her shares to the buyer for $55 per share, resulting in a loss of $500 ($60 – $55 x 100 shares) plus the $200 premium she received.
Risks Involved with Naked Call Options
As illustrated in the example above, selling naked call options can be a risky strategy. While the seller can make a profit if the price of the underlying asset remains below the strike price, there is unlimited downside risk if the price of the asset rises above the strike price. This means that the seller could potentially face significant losses if they are not able to buy back the option before the expiration date.
Conclusion
In conclusion, a naked call option is a type of options contract where the seller sells a call option without owning the underlying asset. While this strategy can be profitable if the price of the underlying asset does not rise above the strike price, it can also result in significant losses if the price does rise above the strike price. It is important for investors to fully understand the risks involved before deciding whether or not to use this strategy. As always, it is recommended to seek the advice of a financial professional before making any investment decisions.