Fri Jul 6, 2007: Out-of-Money Naked Calls (RIMM)

The stock of Research in Motion (NASDAQ-RIMM, 215.35) has been flying high lately. How high can it go? Some option buyers are betting it will be over 260 by December. They're willing to pay $1,100 each for the December 260 call options.

Chart of RIMM Stock

Let's look at the potential income we could get by taking their bet and selling that call option without buying the stock. This would be an uncovered ("naked") option position. Without owning the stock, you'd have to put up a margin deposit instead. Margin requirements vary from broker to broker, but as an example, since this option is so far out of the money, a 10% margin would be typical. This would be $2,153.

Selling a December 260 call for $1,100 on that margin requirement works out to a 51% return, not bad for five months. So what is the risk you're assuming in return for this 10% monthly income?

If RIMM is still below 260 on December 21st, then the option will still be out of the money and it will expire worthless. In that case, the $1,100 income is pure profit.

Above 260 the option will be in the money, and worth $100 for every point that the stock is above 260, because the option buyer could exercise their right to buy ("call") 100 shares of RIMM stock from you at 260. If the market price at that time is for example $265.50 they could sell that stock on the market immediately for a $550 profit. Or they could sell the option back to you, or to some other option writer who wants to avoid being assigned 100 shares of RIMM short in their account.

On the other hand, maybe you'd be happy to sell it short at $260 in which case you wouldn't have to do anything, just wait for it to (hopefully) go back down and then buy back the short position at a profit. You'd have to come up with a 50% margin deposit to hold onto the short position. You could sell a covered put option to bring in additional income while you're waiting for the stock to go back down. This approach is discussed in previous commentaries.

Also discussed in previous commentaries is the situation where there are no shares available for shorting because other investors who own the stock are not willing to loan it out for that purpose. This is rare but if it happens and you still want to have a short position at that time you could just set up a synthetic short position using options.

Remember that with naked call writing your risk of loss is unlimited because the stock could continue to go up.

Calculate the break-even point on this naked call option:

260.00 + 11.00 = 271.00, which is the point above which you'd have a net loss at expiration.

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