In-The-Money Naked Call

The in-the-money naked call strategy involves writing deep-in-the-money call options without owning the underlying stock. It is an alternative to shorting the stock employed when one is bearish to very bearish on the underlying.

Naked Call (ITM) Construction
Sell 1 ITM Call

Limited Profit Potential

The main objective of writing deep-in-the-money naked calls is to collect the premiums when the call options drop in value or expire worthless as the underlying stock price declines. Profit is limited to the premium collected for writing the call options.

The formula for calculating maximum profit is given below:

  • Max Profit = Premium Received - Commissions Paid
  • Max Profit Achieved When Price of Underlying <= Strike Price of Short Call
Naked Call (ITM) Payoff Diagram
Graph showing the expected profit or loss for the naked call (itm) option strategy in relation to the market price of the underlying security on option expiration date.

Unlimited Loss Potential

If the stock price goes up dramatically at expiration, the call writer will be required to satisfy the options requirements to sell the obligated stock to the options holder at the lower strike price by buying the stock from the open market at higher market price. Since there is no limit to how high the stock price can be at expiration, potential losses for writing in-the-money naked calls is therefore theoretically unlimited.

The formula for calculating loss is given below:

  • Maximum Loss = Unlimited
  • Loss Occurs When Price of Underlying > Strike Price of Short Call + Net Premium Received
  • Loss = Price of Underlying - Strike Price of Short Call - Max Profit + Commissions Paid

Breakeven Point(s)

The underlier price at which break-even is achieved for the naked call (itm) position can be calculated using the following formula.

  • Breakeven Point = Strike Price of Short Call + Premium Received

Example

The stock XYZ is currently trading at $48. An options trader decides to writes a JUL 40 in-the-money call for $10. So he receives $1000 for writing the call option.

On expiration date, the stock had rallied to $68. Since the striking price of $40 for the call option is lower than the current trading price, the call is assigned and the writer buys the shares for $6800 and sell it to the options holder at $4000, resulting in a loss of $2800. However, since he received $1000 earlier on, his net loss comes to $1800.

If the stock price drops moderately to $45, the cal writer can realise a profit from the loss in premium value of the call option sold. Since the striking price of $40 for the call option is lower than the current trading price, the call is assigned and the writer buys the shares for $4500 and sell it to the options holder at $4000, resulting in a loss of $500. However, as he had received $1000 for the sale of the call earlier, his profit for the trade is $500.

However, what happens should the stock price had gone down 20 points to $28 instead? Let's take a look.

At $28, the call expires worthless and the writer of the naked call keeps the full $1000 in premiums received as profit.

From the profit graph shown earlier, we can see that the breakeven is at $50 (Call Strike + Premium). So long as the stock price remains at $50 or below, the naked call writer will not suffer any loss.

Note: While we have covered the use of this strategy with reference to stock options, the naked call (itm) is equally applicable using ETF options, index options as well as options on futures.

Commissions

For ease of understanding, the calculations depicted in the above examples did not take into account commission charges as they are relatively small amounts (typically around $10 to $20) and varies across option brokerages.

However, for active traders, commissions can eat up a sizable portion of their profits in the long run. If you trade options actively, it is wise to look for a low commissions broker. Traders who trade large number of contracts in each trade should check out OptionsHouse.com as they offer a low fee of only $0.15 per contract (+$4.95 per trade).

Similar Strategies

The following strategies are similar to the naked call (itm) in that they are also bearish strategies that have limited profit potential and unlimited risk.

Out-Of-The-Money Naked Call
Covered Put

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