The term naked call refers to a strategy in which the seller of a call option does not own the underlying securities outlined in the contract. Naked calls are considered an advanced options strategy, since it carries unlimited risk.
ExplanationThe seller of a call option is referred to as the writer. They are obligated to sell the securities to the holder of the call option if they exercise their right. The buyer of a call pays a fee, known as a premium, to own the right to exercise their option. If the seller of a call does not own a corresponding amount of the underlying security, the option is said to be "naked," which means the seller will have to purchase shares on the open market if the buyer decides to exercise their option.
Generally, the buyer of a call option is bullish on the security, since they believe its price will increase over time. The writer of the option has a bearish, or neutral, view in the case of a covered call. A naked call is one of the riskiest options an investor can write because it carries unlimited risk (in theory).
There are two possible outcomes when writing a naked call:
- Flat Price or Declining Price: the underlying security's value does not rise over the term of the contract, and the buyer of the call does not exercise their right to buy the securities. When this happens, the writer of the call profits from the premium.
- Increasing Price: the underlying security's value increases over the term of the option, and the buyer of the call exercises their right to buy the securities. When this happens, the writer of the naked call must purchase the underlying securities. The writer keeps the premium they were paid; however, they must now purchase securities at a market price that is higher than the price they will be paid by the holder of the call option.