In an earlier article, we looked at selling covered call options. In this article, we will be looking at how to sell naked calls.
Selling naked call options means selling someone else, a buyer the right to buy from you usually 100 shares of some stock or ETF you do not own at a fixed price, called the strike price at or before a specific date in the future.
In return for giving up your rights to the buyer of the call option, you receive the premium. This is a bearish strategy. When you sell naked calls you are taking a bearish position and betting that the price of the underlying stock will decline.
In effect, it isn’t so much that the call option itself is naked, I think the term is more a reflection of the condition of the seller. It reminds me of one of Warren Buffet’s famous remarks about corporate finances: It is only when the tide goes out that you see who has been skinny dipping.
Yes, you guessed it. This is a high-risk strategy. Most brokerage providers are going to want to see some years of experience and a sizeable account with other holdings and then be persuaded to grant you approval to write naked call options.
The potential gain is limited to the option premiums you receive and the potential for loss is theoretically infinite.
This is one of those strategies where if you are caught on the wrong side, your account can be wiped out.
In practice that is more likely to happen if you have an account with a less experienced brokerage platform. New brokerage platforms often don’t have robust risk management in place. The combination of inexperienced traders and inexperienced brokers tends to amplify losses when markets get out of hand.
Terminology long and short
Let’s wade through some terms here so we don’t have to spell everything out all the time.
Selling a naked call is also referred to as being short the call, or having a short position in the call option. That’s what you will have if you are the seller.
Buying a call option is also referred to as being long the call or having a long position in the call option.
Margin is a money provision that your broker extends to you when you are given the approval to trade on margin, i.e. on the short side of trades. Usually, your broker will take into account all the long positions in your portfolio and determine how much margin they will extend to you.
Essentially, if your short positions start to move against you your broker can ask you to close some of them or to sell some of your long positions to cover the losses on your shorts. If you don’t want to sell your long positions to cover your shorts you can choose to transfer more funds into your account. If you have the funds to transfer in of course.
Most brokerage providers are going to watch the exposure to short positions on an ongoing basis and take action if the market moves against those positions.
Under normal circumstances when markets are liquid and prices are being recorded as trades are executed and reflected in revised prices all is fine. However, there are times when the volume of trades exceeds the capacity of the trading systems to properly update and reflect prices.
That’s basically a market meltdown. There are probably more polite and technical terms for it but that is what it amounts to. More on that another time.
Let’s look at some calculations to see how selling naked calls can play out and what the theoretical or statistical chances are of different outcomes.
Let’s consider we have been watching the price of SPY which is an Exchange-Traded Fund, or ETF that tracks the Standard and Poor’s 500 index. The price of SPY is actually 1/10 the index itself.
So today, for example, SPY closed at $389.51 as the index closed at 3,895 at the end of trading.
Calculate Implied Volatility Implications from at-the-money call
We calculate the impact of Implied Volatility of the underlying stock or ETF, from the Implied Volatility of at-the-money calls.
We look on our brokerage platform and find that an at-the-money call option with a strike price of $390 and 30 days to expiry carries a premium of $6.70. We also note that the Implied Volatility that our platform calculates from this information is 17%
So what does that figure of Implied Volatility really mean?
We’ll get into detail on that another time. But in the meantime, the Implied volatility is the percentage measure on either side of the price that is a standard deviation of price variations for a 12 month period. This assumes that price variations follow a normal distribution.
And what that means from basic statistics is that.
- For 68% of the time over the next year, the price will fall within plus and minus one times the Implied Volatility of 17% on either side of the current price.
- For 95% of the time over the next year, the price will fall within plus and minus two times the Implied Volatility of 17% on either side of the current price, and
- For 99.7% of the time over the next year, the price will fall within plus and minus three times the Implied Volatility of 17% on either side of the current price.
Let’s run the calculation further, firstly for a 12 month period.
- 17% on either side of $390 is $323.70 and $456.30
- So as we said our statistical model tells us that 68% of the time the price will fall within these two values,
- 34% of the time it will be between $323.70 and $390,
- 34 % of the time it will be between $390 and $456.30.
- 16% of the time, the price will be below $323.70
- 16% of the time, the price will be above $456.30.
But our option expires in 30 days, not 12 months
Going back to statistical theory, we can convert the annual implied volatility to a different time period by multiplying by a factor equal to, in this case, the square root of 30 divided by 365.
Actually, there are two ways of doing this and two schools of thought. One uses calendar days and one uses trading days. Taking the square root of 30/365 is using calendar days, and taking the square root of 22/252 is using trading days. They give slightly different results.
Personally, I think calendar days make more sense because traders don’t put their emotions on hold over a weekend. Yes, they can only act on them on Monday morning when the markets open but then any pent-up emotions get released and acted upon on Monday.
So again just considering one measure standard deviation but now for a 30 day period, implied volatility is 4.87% and that gives the following.
- 4.87% on either side of $390 is $370.99 and $409.01
- 34% of the time the price will be between $370.99 and $390
- 34% of the time the price will be between $390 and $409.01
- 16% of the time the price will be below $370.99
- 16% of the time the price will be above $409.01
Does this really tell us a lot?
Honestly, yes and no.
As traders and investors, we are far more likely to open options positions because of either what we think might happen to the price of the underlying stock or ETF, or because of what the market tells us is happening now. And from that knowledge of what the market is doing now, we can infer the chances of what it might do next.
Options prices are set by the demand and supply from traders buying and selling them.
Just using the statistical calculations
But going back to statistics for the moment. If we wanted to sell a naked call option on the SPY ETF and we wanted to keep our risk of being wrong statistically down to 16% or thereabouts, we could sell a call option with a strike price of $409, expiring on 31 March. That currently has a premium of $0.65 so we would collect $65.
According to statistics, we would be running a 16% chance that the option would be in-the-money at or before expiration and we would either get assigned or have to cover. We’d have an 84% chance of walking away with our $65 unscathed.
Of course, there is no reason why we might feel comfortable taking a 16% risk. We might be more comfortable with a 20% risk or a 10% risk. It just made the maths easier.
Using technical analysis
As a trader, it is more likely that we will base our estimation of how the odds could play out, in this case on a Fibonacci extension and using moving averages on the price action of the SPY to determine a strike price for selling a naked call option.
What the statistical analysis gives us is the ability to do a sanity check on our trading ideas. You might be comfortable with that 17% risk.
But let’s imagine it is another day and you are watching another stock or ETF and you are about to enter a naked call position. You ran the numbers using implied volatility and you calculate that statistically you stood a 40% chance of the option expiring in-the-money and you only took in $20 for each option premium. Maybe you would decide to walk away from that trade.
Not so naked
There are other ways we can make a naked call position less naked. Maybe we should say scantily clad rather than naked.
A simple way to do this is to limit the losses of a naked call by buying a call on the same underlying with a higher strike price.
In the case of the $409 strike call on the SPY with 30 days to expiration, if we bought a $414 call with the same expiration this would cost $0.32. So instead of pocketing $65 in premium, we would spend another $32 to protect ourselves from potentially infinite losses on the upper end.
Our income would be reduced to $33 but if the price of SPY does move against us, we would see the value of our long position in the $414 call option increase as the value of our short position in the $409 call option decreases.
This is called a vertical spread and because we are still being paid to do it, and it is a bearish strategy, it is called a bearish credit call spread.
What this achieves is that the maximum loss we could incur is the difference between our short position with the $409 strike price and our long position with the $414 strike price, less the premium. So our loss is capped at $467. We will look more closely at options spreads another time.
What this means
Writing naked call options is a high-risk strategy. You would need approval for this level of options trading from your broker and they are only likely to give you that approval if you have been with them for a while and if you have a largish portfolio of other liquid and less volatile assets such as quality and value stocks, ETFs or bonds.
Having said that, if you have an appetite for studying options boards and price movements there may be times when you see opportunities. Options premiums might be higher than you think are justified and you can see the markets are pulling back. You may decide that the time is right to bank some premiums on named calls.
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Questions and answers
Q. Can you sell a call option on a stock you do not own?
A. Yes, if your broker approves your account for naked call options. Selling a call option on a stock you do not own is called selling naked call options.
Q. What is the most you can lose on a call option?
A. If you buy a call option the most you can lose is the premium you paid for it and any brokerage fees and commissions. If you sell a call option your losses are potentially infinite if the stock price increases parabolically.
Q. Are covered calls better than naked calls?
A. Covered calls are less risky than naked calls. But with a covered call, you will either have to buy yourself out of a losing position, in which case it would cost you the same as the naked call, or you will have to give up your underlying stock.
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