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Options Investing Strategies – The Naked Call Option

By Jason Markum

Investing in the stock market is no bed of roses and investing in the options market can be even more complicated if you don’t really know what you’re doing. I have found over the years that your ordinary average individual investor has a more difficult time understanding the options market than they really need to because when you get right down to it- investing in options doesn’t have to be all that complicated.

In this article I would like to discuss one simple options strategy that you can use right away. When I’m done I hope you’ll understand that options investing doesn’t have to be as complicated as many people would have you believe. So let’s get right down to it and discuss the naked call option.

I like this strategy just because it has the word naked in it and any time you can bring anything remotely lewd into the world of investing, well it’s a lot of fun! Unfortunately the naked call option is nothing illicit or even a little naughty, it’s just a simple investing strategy.

This is a much riskier version of your average covered call option that you could write yourself on your own portfolio. In a naked call it is almost exactly the same as a covered call except you don’t own the underlying security at the moment. You still receive the premium but you don’t have the stock yourself at the time that you’ve written the call. Hence the word naked.

Just to refresh your memory in case you don’t remember what a covered call is, say you own a share of stock and you pay $40 for it. If you don’t think that the price is going to rise very much in the future you can sell a covered call for $45 and the premium you can charge for that call may be around a dollar. What that means is someone will give you a dollar today for the right to buy your share of stock in the future at $45. If the price of the stock rises above $45 say to $60, then you will have to sell your share at $45 at which time the other investor will take your share and sell it on the market at $60 and make himself a cool $15 profit. At which point you will not receive any of that $15, you just get the one dollar that you sold the call for. If on the other hand, the share price stays around $40 the option will expire and you will keep the one dollar premium as well as your share of stock that you already owned.

And like I said, a naked call option is that exact strategy except you don’t already own the stock. So who would use such a strategy? Well basically, any investor who is willing to take on a large and sometimes unlimited amount of risk would be drawn to this strategy.

Why is it nearly unlimited in risk? Because the stock price can increase forever and eventually you will have to buy it at whatever price it is selling at. So if a share of stock is currently trading for $40 and you sell a naked call with an exercise price of $45 a share, and that stock shoots up to $80 a share, then you will have to buy at $80 dollars and sell it to whoever purchased the call for $45. The difference between $80 and $45 is how much money you will lose.

But what if the price of the share doesn’t raise to $80, what if it raises to $200? Then you have to buy at $200 and sell it at 45 losing the difference between $45 and $200. It’s unlimited-ly risky because the share price could increase unlimited-ly (is that a word?). In theory it could go up to $100,000 a share like Warren Buffett’s Berkshire Hathaway shares!

Because of this risk, writing naked calls is only recommended for somebody who really knows what they’re doing. For everyone else I suggest you stick to writing covered calls.

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