Naked Call
A naked call is when a trader shorts a call without having stock or other
options to cover or protect it. Since the call is uncovered, it is one of the
riskier trades a trader can make. Recall the at-expiration diagram for the
naked call from Chapter 1, Exhibit 1.3 : Naked TGT Call. Theoretically,
there is limited reward and unlimited risk. Yet there are times when
experienced traders will justify making such a trade. When a stock has been
trading in a range and is expected to continue doing so, traders may wait
until it is near the top of the channel, where there is resistance, and then
short a call.
For example, a trader, Brendan, has been studying a chart of Johnson &
Johnson (JNJ). Brendan notices that for a few months the stock has trading
been in a channel between $60 and $65. As he observes Johnson & Johnson
beginning to approach the resistance level of $65 again, he considers selling
a call to speculate on the stock not rising above $65. Before selling the call,
Brendan consults other technical analysis tools, like ADX/DMI, to confirm
that there is no trend present. ADX/DMI is used by some traders as a filter
to determine the strength of a trend and whether the stock is overbought or
oversold. In this case, the indicator shows no strong trend present. Brendan
then performs due diligence. He studies the news. He looks for anything
specific that could cause the stock to rally. Is the stock a takeover target?
Brendan finds nothing. He then does earnings research to find out when
they will be announced, which is not for almost two more months.
Next, Brendan pulls up an option chain on his computer. He finds that
with the stock trading around $64 per share, the market for the November
65 call (expiring in four weeks) is 0.66 bid at 0.68 offer. Brendan considers
when Johnson & Johnson’s earnings report falls. Although recent earnings
have seldom been a major concern for Johnson & Johnson, he certainly
wants to sell an option expiring before the next earnings report. The
November fits the mold. Brendan sells ten of the November 65 calls at the
bid price of 0.66.
Brendan has a rather straightforward goal. He hopes to see Johnson &
Johnson shares remain below $65 between now and expiration. If he is