Short Call (Naked Call / Uncovered Call)
A naked call is an option trading strategy with very high risk, one that traders use when they expect the stock or other underlying assets to decline or at least stay below the strike price of the option being sold. In this strategy, a call option is being sold without the seller having the underlying.
The Short Call Setup
Let us assume there is an event where a company named StableTech will not be going up in the next few months due to market saturation. You, therefore, decided to sell a naked call option with an $110 strike price, which expires in two months, for a premium of $4 per option.
Who Should Think About Doing It?
The short call is best suited for advanced traders with a high-risk tolerance and a bearish or not strongly bullish view on the underlying. Moreover, traders will use this strategy who want to earn income through premiums provided they have the capital to accept the risks.
How the Strategy Works
By selling a call option, you assign the buyer the right to buy the underlying asset for a predetermined price (the strike price) until expiration. If the asset price remains below the strike price, the option will expire worthless, and you will keep the premium as profit.
Breakeven Process
For the purposes of a short call, breakeven is computed by adding the premium received to the strike price. In this case for StableTech, $110 plus $4 equals $114. This means the stock price must remain below $114 until expiration in order for you to escape a loss.
Sweet Spot
The sweet spot for this strategy is when the underlying asset’s price stays below the strike price, allowing the option to expire worthless and you to retain the entire premium received.
Max Profit Potential
The maximum profit would be the premium received from the sale of the call option. In this example, it would be $4 per share.
Max Loss
Theoretically, the maximum loss could be unlimited because there is no limit to stock price ascent. The larger the degree of stock price rise above $110, the larger the degree of losses incurred.
Risk
It is risky as there are potentially unlimited losses when the stock price increases over the strike price because of selling a call option without being in possession of the underlying stock.
Time Decay
Time decay acts in favor of the short call strategy. If the stock price rides below the strike price ever closer to the expiration date, the premium awarded to the option that you sold would decrease, which is favorable for you, the seller.
Implied Volatility
The strategy thrives on decreasing implied volatility as it generally will create a downward shift in option premiums, thus making the option sold much less valuable-beneficial to him as the seller, as it decreases the possibility of the option actually being exercised.
Conclusion
Short call strategy is attractive considering the ability to earn premiums from a move that appears to be a losing proposition in a declining or stable market. However, given the risk factor and the possibility of incurring unlimited losses, traders need to consider the underlying market conditions carefully, keep proper risk management systems in place, and monitor their positions continuously. Due to the complex risk profile and the potential for major financial loss, the strategy is not recommended for beginners.