Definition
A naked call, in finance and investing, refers to an options strategy where an investor sells call options without owning any of the underlying security. This is a high risk strategy because the potential losses are unlimited if the market price of the underlying asset rises. Meanwhile, the maximum possible gain is restricted to the premium received for selling the call.
Key Takeaways
- A Naked Call refers to an options strategy where an investor writes (sells) call options on the open market without owning the underlying security. This is a highly risky strategy as it exposes the investor to potentially unlimited losses.
- This strategy is primarily used when an investor expects the price of the underlying asset to remain flat or decrease in the future. It provides immediate income to the investor through the premiums received from selling the call options.
- Due to the high level of risk associated with naked calls, only experienced investors with a high risk tolerance and significant capital should consider this strategy. Moreover, the strategy requires a high level of market understanding and competent risk management practices.
Importance
A “naked call” is a significant term in finance because it refers to a risky trading strategy where the trader sells call options without owning any of the underlying securities.
This strategy is considered high-risk as it has the potential for unlimited losses, should the price of the underlying security increase significantly.
A trader may opt for a naked call strategy to profit from an expected drop in the security’s price or remain stagnant.
However, this strategy is typically not recommended for novice or inexperienced investors due to its high-risk nature.
Therefore, understanding the concept of “naked call” is crucial for any trader or investor, as it helps them to assess risks better and make informed trading decisions.
Explanation
The primary purpose of a naked call, which is a type of options strategy, is to generate premium income from selling calls, with expectations that the underlying stock will not exceed the strike price before expiration. Sellers take on the obligation to sell the underlying asset at the strike price, with the anticipation that the price will remain below the strike price, allowing them to pocket the premium.
This strategy is typically used when the investor or trader has a neutral to bearish outlook on the underlying security and believes that its market price will decline or remain stagnant. The use of a naked call can offer potential profit from premiums, but it carries significant risk, especially because the potential loss is unlimited.
If the market price of the asset increases above the strike price, the seller is obligated to fulfill the contract, which can lead to large losses if the price of the asset rises significantly. Therefore, naked calls are generally considered appropriate only for experienced investors who understand the dynamics and risks of options trading.
Despite this risk, the strategy is appealing to some because it has the potential for significant income generation and can provide a hedge against a downward or neutral market shift.
Examples of Naked call
A naked call in finance takes place when an investor sells call options without owning the underlying security. Doing this leaves the investor exposed (hence, “naked”) if the option is exercised and they need to deliver the security. Here are three real-world examples:
Stock Market Investment: Suppose an investor sells 10 call options for stock XYZ, betting that its price will not go above $50 per share by a specified expiration date. However, the investor does not actually own any shares of XYZ. If the stock price goes above $50 before the options expire, the investor will need to purchase the shares at the higher market price to fulfill the order, potentially resulting in a significant loss. This is a classic example of a naked call operation.
Forex Trading: A trader could sell a call option for a currency pair (like USD/EUR), betting the USD will not strengthen against the euro beyond a specific point. If the dollar does strengthen beyond that rate, the investor, not owning the underlying forex units, will need to buy them at the higher rate to meet his obligation, thereby running into losses.
Commodity Trading: An investor sells a call option for a commodity – like oil or gold, anticipating that the price will not rise beyond a specific level. But, if the price of the commodity hikes, the investor, not holding the commodity’s underlying futures contract, will need to enter the market to buy the commodity at the new, more expensive rate to fulfill their obligation, causing a significant loss. This exemplifies a naked call in commodity trading.
Frequently Asked Questions about Naked Call
What is a Naked Call?
A naked call, also known as an uncovered call, is an options strategy in which a call option is written (sold) by an investor who does not own the underlying security. This strategy involves unlimited risk due to the potential for the underlying asset to increase indefinitely, while profit potential is limited to the premium received for selling the call.
What is the risk involved with Naked Call?
The risk with a naked call is unlimited. Because the seller doesn’t own the underlying asset, if the asset’s price rises significantly, the seller may need to purchase the asset at the increased price to cover the call. This can lead to potentially unlimited losses. The maximum profit, however, is limited to the premium received when selling the call.
Who typically uses Naked Call Strategy?
Naked calls are generally used by more experienced traders who are comfortable and knowledgeable about managing the potential risks involved. It is not recommended for beginners due to the high level of risk associated with this strategy.
Can you offset the risks of a Naked Call?
While the risks of a naked call cannot be eliminated completely, they can be managed. Traders may use stop loss orders to limit losses, may diversify their portfolio to spread the risk, or may use other trading strategies in conjunction with naked calls to help offset potential losses.
Related Entrepreneurship Terms
- Option Premium
- Exercise Price
- Margin Requirement
- Out of The Money (OTM)
- Short Selling
Sources for More Information
- Investopedia: This website provides a comprehensive definition of a ‘Naked Call’, as well as examples and related concepts. Find the related article here.
- MarketWatch: This platform features news and learning resources related to financial markets and instruments, including naked calls.
- Fidelity: A platform that covers a variety of financial topics, including concepts such as Options Trading, where ‘Naked Call’ is used.
- The Balance: A comprehensive resource for all things finance, it provides a detailed explanation of ‘Naked Call’ and related strategies.
