Mon Feb 6, 2006: General Motors (NYSE-GM) Naked Call Example

Naked call writing, like covered call writing, seeks to produce profits by selling call options that decline in value when a stock goes down, or stays the same, or rises less than the premium amount received.

Writing covered calls is generally considered less risky because in a situation where the underlying stock rises sharply, the option writer simply has the stock called away. There is no additional liability in terms of having to buy back the call option at a loss. The covered writer can always keep the full premium received. The option either expires worthless or is exercised by the buyer. In the second case the writer is assigned, and the stock is sold at the strike price.

Writing naked calls exposes the seller to unlimited upside risk. If the stock price moves above the strike price by expiration day (the third Friday of each month), the naked option writer must either buy back the option or have the underlying stock sold short in his or her account. Further, as the stock increases in price the margin requirement increases. Margin calls can force an option writer out of a position at a loss prior to expiration.

What is the motivation, then, to write naked calls?

First, there is the fact that when writing a covered call option, owning the underlying stock has its own risk. The stock could decline in price by more than the amount received for selling the call. This particular risk is avoided when selling naked calls because the underlying stock is not purchased when the call is written.

Second, initial margin requirements for naked writing can be lower, resulting in higher potential profits in percentage terms. For example, today GM stock closed at $23.34 per share and the closing bid for the March 25 calls was $1.20. Selling this as a covered call with 50% down on the purchase price would cost $1,167 minus the option income for a net investment of $1,047. The unchanged yield on margin would be 11.5% (less commissions and margin interest). Naked margin would typically be only 30% of the stock price minus the out-of-money amount ($700.20 - $166.00) or $534.20 so the unchanged yield on initial margin would be 22.5%.

Inexperienced naked call writers often select stocks that have been in strong uptrends for a while and then have a drop. Thinking the uptrend is finally over, they sell a naked call, only to lose money when the stock resumes its uptrend and makes yet another new high. Experienced naked call writers usually select stocks that have been in strong downtrends for a while and then have a rally. Realizing it's probably just another temporary bounce, that's when they sell the naked call.

Inexperienced naked call writers often select stocks that have been in strong uptrends for a while and then have a drop. Thinking the uptrend is finally over, they sell a naked call, only to lose money when the stock resumes its uptrend and makes yet another new high. Experienced naked call writers usually select stocks that have been in strong downtrends for a while and then have a rally. Realizing it's probably just another temporary bounce, that's when they sell the naked call.

Hey! He repeated that same paragraph again by mistake!

No, I did it on purpose.

Because I'm trying to help you.

Read it a few dozen more times.

And best of luck with your option investments!