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Short (Naked) Call: Definition, How It Works, Importance, and Trading          

Short (Naked) Call: Definition, How It Works, Importance, and Trading

Short (Naked) Call: Definition, How It Works, Importance, and Trading

A short naked call is a type of high-risk options strategy. A short naked call is not a conservative trading strategy, and the investor sells or writes a call option without possessing the underlying stock. A short naked call is also referred to as an uncovered call, as it doesn’t have the backing of actual security. 

The Short naked call strategy is highly risky and has the potential for unlimited losses. Experienced traders generally prefer this Strategy. Naked call options are also exercised by big corporations, which can successfully diversify the risks. 

What is a Short (Naked) Call?

A naked call is a type of option strategy where an investor writes or sells a call option without the security of owning the underlying stock. The naked call strategy is aggressive and involves huge risks. It is usually used only when the trader is certain about the bearish market view on the underlying security.

What is a Short (Naked) Call
Short (Naked) Call: Definition, How It Works, Importance, and Trading 7

An investor using this Strategy usually has a bearish market view and is betting that the price at expiration will be below the option’s strike price. The strike price is the price at which the investor writes or sells the call option. Fewer profits or loss on the trade is determined when any price at expiration is above the strike price. 

This Strategy is based on selling a call option, and the primary goal is to collect the option’s premium. The Maximum Loss faced by a trader is unlimited as the market rises and the maximum gain is limited to the premium received for selling the call option.

What is the other term for a Short (Naked) Call?

The other term for a short naked call is an uncovered call or an unhedged short call. The short naked call is usually compared with a naked put. The short naked call is a high probability bearish options trading strategy with unlimited risk. The investor sells or writes the call option and takes a short call position. There is potentially unlimited loss, and the trader or investor has no ownership of the underlying security.

How does a Short (Naked) Call work?

A short naked call is also referred to as an uncovered call. A short naked call happens when the writer of a call option takes a short position without the protection of actual securities at a certain price by a certain date. A short position is the process where an investor sells the stock that he does not own. The price which is agreed upon is called the strike price, and the date is called the expiration date.

How does a Short (Naked) Call work
Short (Naked) Call: Definition, How It Works, Importance, and Trading 8

Here is an image of the naked call option. The writer is considered naked as the options are not held or owned by him. Traders and Investors mainly use the short naked call option strategy as they potentially offer traders income without any significant cost. The income here is the premium received by the sellers for selling the call option. This is the fee paid by the buyers for the option. It is also the maximum profit made by them, and it is limited.

The objective of the short naked call is to ensure that the option expires without the call being exercised, as it provides the investor with a full premium. The investor is exposed to unlimited risk if the option is expired. This means that there is no limit to which the stock prices could rise.

The investors basically use the short naked call strategy for the profit capped at the premium, which is earned immediately after the contract is sold. The investor is betting on a downward price movement direction with a bearish market view. There is a possibility that the stock price increases, and the investor is left with a loss as there is no protection from a downward price shift. The loss here is unlimited as it is a risky strategy.

How does a Short (Naked) Call differ from other Basic Option Strategies?

The primary difference between a naked call and other strategies that involve selling an option is the lack of collateral held by the seller. The short naked call also has a bearish or neutral view, while other other targets have a bullish outlook.

The short naked call is also highly risky, and it has the potential for unlimited loss. Other strategies, like long calls, have limited loss. The short Naked call also has no ownership, which helps the trader from other significant charges, while the covered call has ownership of other underlying stock. These are the basic differences from other strategies. 

How do Option Greeks provide invaluable insights to Short (Naked) Call?

Options traders provide invaluable insights to short naked calls by following the rates of change of four main variables and Rho. Here are the 5 variables.

  1. Delta: Delta measures the change in an option’s price for a Rs 1 move in the underlying security. The naked call has a negative delta, and it changes with the decrease or stability in the stock price.
  2. Gamma: Gamma quantifies the rate of change of delta. The naked call option has a negative gamma.
  3. Theta: Theta is also called time decay. Theta measures the dollar change in an option’s price based on the passage of time. The naked call option has a positive theta. The options tend to decline in value over time as they approach their expiration date, holding all the other factors equal.
  4. Vega: Vega measures the change in an option’s price based on a 1% move up or down in the implied volatility of the underlying. The naked call option has negative Vega.
  5. Rho: Rho reflects changes in interest rates, specifically the risk-free interest rate. Rho is not a specifically monitored component. 

The variables are a reflection of the theoretical value of an option given the value and changes in the value of the variables. Options don’t generally behave as predicted, and there are too many moving parts. 

What is the importance of a Short (Naked) Call in Options Trading?

The importance of short naked calls in options trading is that the traders benefit from time decay. The short naked call is also an income Strategy that can be used in combination with a long stock position to generate extra income (covered call). The short naked call also has a high probability of success, and it is best for traders who believe a security will be either neutral or fall in value.

A naked call gives an investor the ability to generate premium income without directly selling the underlying security. The premium received is the sole motive for writing an uncovered call option. An important factor of the short naked call strategy is that it is flexible. This means that the traders can choose the strike price and expiration dates according to their style and plans. This also helps the traders with risk management. 

How to Write a Short (Naked) Call?

A short Naked call is selling call options on a stock without actually owning the underlying shares. The process of writing naked call options is intricate and requires a significant level of discipline. Naked call options writers are also subjected to an unlimited risk, but they start with the option premium as a buffer.

The first step in writing a short naked call is that the option seller or writer makes sure that the stock price decreases or stays below the option’s strike price. This allows the writer to keep the option premium received from the buyer. The buyer can exercise the option if there is a rise in price above the strike price, which results in a loss for the options seller.

An important step in writing a naked call is that the option seller sells a call option contract on a stock in exchange for a premium paid by the buyer of the options. The seller receives the option premium but is obligated to sell the stock at the strike price if the option buyer exercises their right. The option seller’s potential profit is limited to the premium received, while their potential losses are unlimited because the stock’s price rise can rise indefinitely. Therefore, there is limited profit with a huge potential for upside risk.

This Strategy is usually used by investors when they confirm that the share prices are not going to move upward and speculate a small or moderate drop in the underlying stock. 

The payoff for writing naked call options is similar to writing a covered call. The only difference is at the time of exercise by the buyer, the seller has to purchase the underlying from the market or has to borrow the shares from the broker and sell it to the buyer at the strike price. 

The whole process of writing a call option starts with announcing the selling of call options. The seller then gives the rights to the buyers. The buyers usually buy the stock at a strike price, and this is usually done anytime before expiration. Writing call options is suitable for investors with a neutral to slightly bearish outlook on the underlying asset. It can be used to generate income or hedge an existing long position. 

How to close a Short (Naked) Call?

Closing a Short naked call is buying back the option any time before expiration. A short naked call can be purchased back to exit the trade. The option writer can close out the position by buying back if the option price decreases, which will cancel the obligation to sell the underlying asset. The same quantity of shares or securities that were initially sold short is usually bought back. This process is known as covering the temporary position. Buying back the shares allows the short seller to return them to the lender and exit the function.

There are multiple ways to close a short naked call anytime before expiration. One way is to enter a Buy To Close (BTC) order, and the contract will be purchased at the market or limit price. The premium paid will be debited from the account. A loss is detected if the contract is purchased for more premium than initially collected, and a profit is detected if the contract is purchased for less premium than initially collected.

Another way to close out a short naked call is when the call is Out Of Money (OTM). Out of money (OTM) refers to a situation where the underlying asset’s price is lower than the strike price of the call. This buyback may result in a profit if the option premium has decreased or a loss if the premium has increased because of a rise in the stock’s price.

The whole process of closing a short naked call starts with waiting for the option to expire and retain the premium. The traders buy back the Call Option, and this is usually bought at a lower strike price.

What are the things to consider when using the Short (Naked) Call strategy?

There are 8 major things to consider when using a short naked call strategy. A trader must consider the major points before trading using the short naked call strategy, as it is very aggressive. The short call is a high-probability bearish options trading strategy with unlimited risk. Here are the 8 things to consider while using the short naked Strategy. 

1.When to use it

The short naked call is used by the trader when there is a bearish market view. The trader expects the price of the underlying asset to go down in the near future. This Strategy is used only when the trader is certain about the bearish market view. The market direction and the market volatility have to be bearish.

2. Maximum potential profit

The maximum potential profit is limited to the premium received for selling the option. The profit is capped at the premium, which is earned immediately after the contract is sold. The maximum profit achieved when the price of an underlying asset goes down and an option is not exercised is less than or equal to the strike price of a short call. The potential profit is usually the credit received. Here is the formula for maximum profit:

Maximum Profit Potential = Credit received 100

3. Maximum potential loss

The maximum potential loss on a short naked call is unlimited as the market rises. The option seller faces substantial losses if the price of the stock rises significantly. Maximum loss on a short (naked) call when the underlying asset goes up and the option is exercised is unlimited. A loss occurs when the price of the underlying asset is greater than the Strike Price of the Short Call and the premium received. 

Here is the formula for maximum potential loss:

Maximum Loss Potential = Price of Underlying – Strike Price of Short Call – Premium Received

4. Margin Requirement

The margin requirements for selling naked call options to retain the positions are quite high. The traders have rigid requirements as per their preferences. The greater one from the following values is usually considered. 

Here is the formula for calculating margin requirements. 

Margin Requirement = 10% of the underlying security value + Received upfront premium.

Margin Requirement = 20% of the underlying security value + Received upfront premium – Out of the money (OTM) amount (if any)

5. Time Decay

Time Decay is also called theta. The options tend to decline in value over time as they approach their expiration date, holding all the other factors equal. This rate of change in the value of an option is referred to as theta. An option’s theta value represents how much an option’s price decreases per day as it matures, and this is a negative.

Theta will increase as the option expiration date gets closer. The calculation of theta or any of the other Greeks requires using advanced mathematical formulas, and this depends on the particular pricing model you choose. Options investors typically calculate theta on a daily or weekly basis.

The theta is smaller for options that are far away from their expiration date and larger as you get closer to expiration. A short option seller is positive theta, which equates to selling time. The option seller can capture profit if the underlying security is neutral or is bearish.

6. Who should use it

All traders can use the short naked call strategy. The short naked call strategy offers the traders income without any significant cost as they don’t own it, but it is highly risky. It is important to make sure that the short naked call strategy should be used only by highly experienced traders and investors to avoid potential losses. This Strategy is generally preferred by big corporations that can successfully diversify the risks.

7. Implied Volatility

Implied volatility is the expected daily price variability of the underlying security, and Implied volatility reflects the possibility of future price movements. The implied volatility must decrease in a short naked call strategy as that will decrease the price of the option that is to be sold. The larger and more frequent the price changes, the more volatile the underlying security. The trader should close the position prior to expiration as it is less expensive. As time passes, The implied volatility and the stock price stay the same as time passes because a short call option will shed value, which is desirable for short calls. 

8. Breakeven at expiration

The short naked call strategy has a breakeven point referring to the value of security, which is equivalent to the sum of its strike price and premium amount. Break-even is achieved when the price of the underlying is equal to the total strike price and premium received. 

Here is the formula for calculating breakeven at expiration.

Expiration Breakeven Price = Call Strike Price + credit Received

9. The sweet spot

The sweet spot is Strategy, where the underlying stock price is below the strike price at expiration. This Strategy is perfect for traders or naked call writers, as the traders get the maximum profit. The call option expires, and the traders get the entire premium, and they make the maximum profit. This Strategy is enticing to some traders because of this reason.  

What is an example of a Short (Naked) Call?

Here is an example of a short naked call

An investor sells a naked call option ABC stock for a stock price of Rs 800/-

at a premium of Rs 30/- with a maturity of one month. The share price moves to Rs 1000/- after a month on the expiry date. The investor has to buy the shares of ABC for Rs 1000/- and sell them to the buyer for Rs 800. The loss faced by the investor is Rs 200. The investor would have earned a premium if the share price was Rs 500/-. As in this scenario, the options expire out of the money, and the buyer will not exercise it.

 Here is the payoff:

Case 1: Options expire Out of Money

The strike price of ABC

800

Option premium

30

Price at maturity

1000

Net Pay Off

-170

Case 2: Options expire In the Money

The strike price of ABC

800

Option premium

30

Price at maturity

500

Net Pay Off

30

The price at maturity is less than the strike price of ABC, so the investor does not face any loss, and the maximum profit of Rs 30/- is received by the investor.

What are the advantages of Short (Naked) Calls?

These are the 5 advantages of short naked calls.

  1. Premium income: The option seller receives income without any other significant cost. This premium can be used to offset other investments or generate income.
  2. Profit from declining stock price: This Strategy allows you to profit from falling prices in the underlying asset. The seller can keep the premium as profit If the stock price remains below the strike price, and the option will expire worthless.
  3. Limited capital requirement: Writing naked calls requires a margin account, but the initial capital requirement is lower than purchasing the underlying stock. 
  4. Short position: Taking a short position gives investors the opportunity to make money not only when stocks go up but also when the stock goes down. Short selling will also act as a hedging tool.
  5. Diversification: It also helps in diversification because by adopting both short and long positions, the investor gets the opportunity to gain from different market conditions.

These are the advantages of short naked calls, which traders and investors use to develop a successful trading strategy and make informed trading decisions. Traders can use the advantages to find the optimal setting that aligns with their trading strategy and risk tolerance.

What are the disadvantages of Short (Naked) Calls?

There are 5 disadvantages of short naked calls.

  1. Unlimited potential losses: The option seller may face substantial losses if the stock’s price rises significantly.
  2. Margin requirements: Selling naked calls requires a margin account, and the margin requirement can change with fluctuations in the stock price. Naked call Write is a credit strategy that involves margin, and beginners are rarely allowed to execute it with most online brokers.
  3. High-risk Strategy: Naked calls are considered high-risk because of the potential for unlimited losses and may not be suitable for all investors. Experienced and speculative traders are only suitable, which makes it not beginner-friendly.
  4. Potential profit is limited: The potential profit is limited, so if the stock goes into a huge drop, there will be no profit.
  5. Limited Rewards: Rewards are limited to premium received only. The trader receives no extra profit.

These are the disadvantages, and traders and investors must use Option Moneyness with other technical analysis tools and indicators to confirm signals and minimize the risk of poor trading decisions. Traders must also find the optimal setting that aligns with their trading strategy and risk tolerance.

Is doing a Short (Naked) Call better than a Long Call?

No, a long naked call is better than a short naked call. Long calls have a bullish view, and the Strategy is good for options beginners. Long calls also have unlimited rewards and limited risk. It is safer compared to short naked calls. This also changes depending on factors like risk tolerance, market outlook, and the style and preference of the traders and investors.

What is the difference between Short (Naked) Call and Short Covered Call?

Here are the 5 differences between short naked call and short covered call

Short Naked Call:Short Covered Call:
A short naked call is an options strategy in which an investor writes or sells call options on the open market without owning the underlying security. A short naked call is also referred to as an uncovered call.A short covered call is an options strategy in which the investor selling or writing call options owns an equivalent amount of the underlying security. A short naked call is also referred to as a covered call write.
An investor executes a short naked call by holding a short position in an asset and writing or selling call options on that same asset to generate an income stream. 2) An investor executes a short covered call by holding a long position in an asset and writing or selling call options on that same asset to generate an income stream. 
The short naked call is an advance level strategy and the investor has a bearish view of the market. 3) The short covered call is an advance level strategy and the investor has a bullish view of the market. 
The break even is achieved by adding the Strike Price of Short Call and the premium received.4) The break even  is achieved by subtracting the purchase price of Short Call and the premium received.
The short naked call Strategy is an aggressive strategy and involves huge risks. It should be used only when the trader is certain about the bearish market view on the underlying securities.5) The covered call option strategy works well when the trader has a Bullish market view and the price of the holdings moderately rise in the future.

These are the basic differences between short naked calls and short covered calls. It is important to differentiate between a short naked call and a short covered call before investing as it helps in formulating options trading strategies, and they provide insights but also represent different aspects of an option’s characteristics.

What is the difference between a Short (Naked) Call and a Short (Naked) Put?

Here are the 5 differences between short naked call and short naked put.

Short Naked Call: Short Naked Put:
A short naked call is the process of selling a stock to the call buyer at the strike price when it is exercised.A short naked put is the process of buying a stock from the put buyer at the strike price when it is exercised. 
The short naked call is bearish or a neutral strategy. The investor has a bearish view of the market. 2) The short naked put is a bullish or a neutral strategy. The investor has a bullish view of the market.
The buyer of the short naked call option benefits from an increase in the price of the underlying securities.  3) The buyer of the short naked put option benefits from a decrease in the price of the underlying securities. 
The investor expects a rise in the prices for a short naked call option and the buyer pays the seller a premium.4) The investor expects a fall in the prices for a short naked put option and the buyer pays the seller a premium. 
The gains in a short naked call option is unlimited as the price cannot be capped.5) The gains in a short naked put option are limited as the price can fall steadily but will stop at zero.

These are the basic differences between short naked call and short naked put. It is important that a trader should know the basic  differences between a short naked call and a short naked put before investing as it helps with formulating the right plan.

Arjun
Arjun Remesh

Head of Content

Arjun is a seasoned stock market content expert with over 7 years of experience in stock market, technical & fundamental analysis. Since 2020, he has been a key contributor to Strike platform. Arjun is an active stock market investor with his in-depth stock market analysis knowledge. Arjun is also an certified stock market researcher from Indiacharts, mentored by Rohit Srivastava.

Shivam
Shivam Gaba

Reviewer of Content

Shivam is a stock market content expert with CFTe certification. He is been trading from last 8 years in indian stock market. He has a vast knowledge in technical analysis, financial market education, product management, risk assessment, derivatives trading & market Research. He won Zerodha 60-Day Challenge thrice in a row. He is being mentored by Rohit Srivastava, Indiacharts.

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