The out-of-the-money naked call strategy involves writing out-of-the-money call options without owning the underlying stock. It is a premium collection options strategy employed when one is neutral to mildly bearish on the underlying.
|Naked Call (OTM) Construction|
|Sell 1 OTM Call|
The main objective of writing naked calls is to collect the premiums when the options expire worthless. One would write an out-of-the-money naked call every month and if the stock price stays flat or drops, one would pocket the premiums and repeat the process as long as the perceived market condition remains unchanged.
Maximum gain is limited and is equal to the premium collected for selling the call options.
The formula for calculating maximum profit is given below:
If the stock price goes up dramatically at expiration, the out-of-the-money naked 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 the higher market price. Since there is no limit to how high the stock price can be at expiration, maximum potential losses for writing out-of-the-money naked calls is therefore theoretically unlimited.
The formula for calculating loss is given below:
The underlier price at which break-even is achieved for the naked call (otm) position can be calculated using the following formula.
The stock XYZ is currently trading at $48. An options trader decides to writes a JUL 50 out-of-the-money naked call for $3. So he receives $300 for writing the call option.
On expiration date, the stock had rallied to $68. Since the striking price of $50 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 $5000, resulting in a loss of $1800. However, since he received $300 earlier on, his net loss is $1500.
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 $300 in premiums received as profit.
From the profit graph above, we can see that the breakeven is at $53 (Call Strike + Premium). So long as the stock price remains at $53 or below, the naked call writer will not suffer any loss.
A more bearish version of this strategy with a higher potential profit is to write deep-in-the-money naked calls.
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).
The following strategies are similar to the naked call (otm) in that they are also bearish strategies that have limited profit potential and unlimited risk.
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