Tue Jun 26, 2007: Amazon Naked Calls

The stock of Amazon.com Inc. (NASDAQ-AMZN) closed today at $67.48 per share, nearly double the price of three months ago.

Chart of AMZN Stock

January 80.00 call options are currently bid at 3.80, which is $380 per contract for 100 shares.

Selling this option could return a maximum profit of 49.2% on a margin deposit of $772 per contract, if AMZN stock closes at 80 or below on expiration day January 18th, 2008.

2008 Options Expiration Calendar

2007 Options Expiration Calendar

This would be an income of approximately 7% per month.

Calculate the break-even point:

80.00 + 3.80 = 83.80, which is the price above which you'd lose money at expiration.

Option writers making this trade would be hoping that AMZN stock goes down, stays about the same, or goes up but still stays below 80 by expiration day.

When selling naked calls, the risk of loss is unlimited, since there is nothing to guarantee that the stock will not keep climbing higher in price. Your net loss would be $100 for every point higher than 83.80 since you'd have to buy back the option or let it be assigned.

If you bought it back it would cost about $100 for every point above 80. For example at 85.72 it would cost at least $572 which would give you a net loss. If it was at 81.50 it would cost you about $150 which would leave you with a net profit.

If assigned, your broker would automatically sell short for you 100 shares of AMZN stock in your account to meet your obligation to the buyer of the call option who exercised his right to "call" (buy) the stock from you at $80 per share, even though the market price would be higher at that point so you'd be holding a short position with a loss. You wouldn't actually realize a loss until you bought the stock back to cover the short, so you could wait and hope that the price went back down. And you could keep the income from the option you sold. But if the stock continued higher your loss on the short position would increase.

If the stock finished below 80, the buyer would have no reason to exercise his option. It would simply expire worthless and you'd keep the entire $380 income as your profit. Since expiration is in 2008, taxes on this profit might not be due until April 15, 2009. Ask your tax advisor.

Until next time, best of luck with your option investments!