Covered call versus naked call option strategies

Covered and naked call options strategies are a way to express a bearish view using options. We compare the two and explain the objectives and risks

 

Reminder: options are derivative contracts that offer traders the right but not the obligation to buy (call) or sell (put) an underling asset at a specific price before the option expires.

 

Short call options strategies

While the hoped-for outcome in covered and naked call options strategies is the same, the objective of using the options contract varies. The main distinction is between speculating and hedging.

The naked call options writer is purely aiming to make a profit from a short bet on the market. The covered call writer is aiming to add income to or hedge a long position. But all options writing involves some amount of speculation about what the price will do. Even if hedging, the reason for taking out the hedge is a belief the asset you own could go down temporarily.

 

Covered call option strategy

 

A covered call is when an options trader writes (sells) a call option in the same underlying asset that they have a position in. When the trader writes an option they receive the premium from the buyer as their income on the trade. The trader can use his position in the underlying to ‘cover’ the options trade in case the buyer wants to exercise their call option.

 

Objective:

The options trader in this instance is looking to add some extra income from an options trade on top of their long position in the underlying. The ideal outcome for the trader using a covered call strategy is that their position in the underlying goes up over the long term but that in the time from writing the call to its expiry that the underlying market goes down or sideways.

 

Risk:

The adverse scenario for the covered call options trader is that the option they wrote trades above the strike price because then they must deliver the agreed amount of the underlying asset to the option buyer at the strike price. They will have sold their shares at less than the current market price.

 

Payoff diagram

This represents what the profit and loss the covered call options writer can expect to make given the movement in the asset price relative to the premium they received.

covered call payoff diagram

Source: quora.com

 

Example:

An options trader owns 100 shares of Apple stock (AAPL) and decides to sell a call option with a strike price $50 above the current market price and expires in 30 days. They would receive a premium of $5 per share. This is called an out-of-the-money (OTM) option because it has no intrinsic value because it cannot be exercised.

If AAPL falls or goes up by less than $50 then the options trader earns the premium and option expires worthless. In the case AAPL stock rises the options trader has a net profit of the premium. In case it falls, the premium has offset some of the loss in the underlying long position.

If AAPL rises by more than $50 then the buyer would exercise their call option and the covered call option trader would keep their premium as a profit and sell the shares at the strike price, losing the difference of $50 per share in unrealised profit.

 

Naked call option strategy

The naked call option is the name used to describe what is basically an ‘uncovered’ or unsecured call option strategy. As we described above, the covered call option trader is writing a call option that is covered by an underlying long position. In essence the trader owns the stock they are offering to sell in the call options contract. The naked call option strategy involves writing a call option on a market that the trader has no underlying position in. Put another way, the naked option seller does not own what they are offering to sell.

 

Objective

A naked call options strategy is an aggressive and risky trade. The idea is much less about adding income to or hedging an existing position- and is more of an outright speculation that an asset will go down in value. Said differently, the naked call option trader wants the same outcome as the covered call options trader – for the underlying asset to stay the same value or fall BUT they are taking more risk to do so.

 

Risk

What the naked call options trader doesn’t want to see is the underlying asset move above the strike price. If this happens, they must buy the asset on the open market and then sell it to the call option buyer at the (lower) strike price. The options writer will have lost the full difference between the market price and the strike price.

It can be said that the naked call option writer is taking a bearish position in the market like the buyer of a put option. The key difference is that the naked call option has unlimited risk because the price can go up infinitely, whereas the put buyer has capped their risk by the size of the premium that they paid for the put option.

 

Payoff diagram

This represents what the profit and loss the naked call options writer can expect to make given the movement in the asset price relative to the premium they received.

naked call option payoff diagram

 

Example

An American options trader owns no euros but nonetheless decides to write (sell) a call options contract in EUR/USD with a strike price at the current forex market price, which expires in 60 days. This would be selling an at-the-money (ATM), where the strike price and spot exchange rate are equal. They receive a premium of 50 pips in premium.

If EUR/USD stays the same or falls in value, the naked call option writer will keep their premium with no loss. If EUR/USD moves higher by any amount, the options buyer will exercise their call option but the naked seller will only lose money when the difference between the strike price and the market price exceeds the value of the premium they received.

 

 

Read our next article: Top 7 Tweets of the day - 30th of October 2020

Related articles

How to trade options

How to trade options

No pre-earnings delirium for Tesla DAY AHEAD

No pre-earnings delirium for Tesla - DAY AHEAD

Options implied volatility can predict periods of high risk

Options implied volatility can predict periods of high risk (like a contested election)

A put-call ratio equal to dotcom bubble screams sell stocks

A put-call ratio equal to dotcom bubble screams sell stocks! Should we listen?

bg_nwsletter