38 lines
3.0 KiB
Plaintext
38 lines
3.0 KiB
Plaintext
Qapter 5: Naked Call Writing 133
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THE UNCOVERED (NAKED) CALL OPTION
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When one sells a call option without owning the underlying stock or any equivalent
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security (convertible stock or bond or another call option), he is considered to have
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written an uncovered call option. This strategy has limited profit potential and theo
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retically unlimited loss. For this reason, this strategy is unsuitable for some investors.
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This fact is not particularly attractive, but since there is no actual cash investment
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required to write a naked call ( the position can be financed with collateral loan value
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of marginable securities), the strategy can be operated as an adjunct to many other
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investment strategies.
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A simple example will outline the basic profit and loss potential from naked
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writing.
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Example: XYZ is selling at 50 and a July 50 call is selling for 5. If one were to sell the
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July 50 call naked - that is, without owning XYZ stock, or any security convertible into
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XYZ, or another call option on XYZ - he could make, at most, 5 points of profit. This
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profit would accrue if XYZ were at or anywhere below 50 at July expiration, as the
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call would then expire worthless. If XYZ were to rise, however, the naked writer
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could potentially lose large sums of money. Should the stock climb to 100, say, the
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call would be at a price of 50. If the writer then covered (bought back) the call for a
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price of 50, he would have a loss of 45 points on the transaction. In theory, this loss
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is unlimited, although in practice the loss is limited by time. The stock cannot rise an
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infinite amount during the life of the call. Clearly, defensive strategies are important
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in this approach, as one would never want to let a loss run as far as the one here.
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Table 5-1 and Figure 5-1 (solid line) depict the results of this position at July expira
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tion. Note that the break-even point in this example is 55. That is, if XYZ rose 10%,
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or 5 points, at expiration, the naked writer would break even. He could buy the call
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back at parity, 5 points, which is exactly what he sold it for. There is some room for
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error to the upside. A naked write will not necessarily lose money if the stock moves
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up. It will only lose if the stock advances by more than the amount of the time value
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premium that was in the call when it was originally written.
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Naked writing is not the same as a short sale of the underlying stock. While both
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strategies have large potential risk, the short sale has much higher reward potential,
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but the naked write will do better if the underlying stock remains relatively
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unchanged. It is possible for the naked writer to make money in situations when the
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short seller would have lost money. Using the example above, suppose one investor
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had written the July 50 call naked for 5 points while another investor sold the stock
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short at 50. If XYZ were at 52 at expiration, the naked writer could buy the call back
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at parity, 2 points, for a 3-point profit. The short seller would have a 2-point loss. |