Why naked call writing is risky compare to Covered call?

Question

I know that with a covered call you own the underlying and sell a call and with a naked call you don't own the underlying. Either way, if the underlying finishes in-the-money, you are assigned and you have to sell the underlying shares at the strike price.

What I don't get it why a naked call is so much riskier than a covered call writing?

Answer 1

If the buyer exercises your option, you will have to give him the stock. If you already own the stock, the worst that can happen is you have to give him your stock, thus losing the money you spend to buy it. So the most you can lose is what you already spent to buy the stock (minus the price the buyer paid for your option).

If you don't own the stock, you will have to buy it. But if the stock skyrockets in value, it will be very expensive to buy it. If for instance you buy the stock when it is worth $100, sell your covered call, and the next day the stock shoots to $1000, you will lose the $100 you got from the purchase of the stock. But if you had used a naked call, you would have to buy the stock at $1000, and you would lose $900.

Since there is no limit to how high the stock can go, there is no limit to how much money you may lose.

Answer 2

The math in these answers and comments is correct but most have mistakenly compared the opportunity risk of a covered call with the upside short risk of a naked call (the underlying rising in both positions).

Comparing the two properly requires defining whether to strike price sold is in-the-money, at-the-money, or out-of--the-money ... and the answer will vary depending on which one is chosen. I'm not going to dissect all three. Since people tend to sell OTM covered calls more often than not, I'm going to go with OTM and my answer is going to set some hair on fire (g).

On an expiration basis, if you sell a naked call, it doesn't become problematic until the underlying goes ITM. You have a buffer of the distance up to the strike price plus the premium received. For a covered call, if the underlying begins dropping, you lose on it immediately and your only buffer is the amount of premium received. IOW, in terms of risk, the naked call will outperform the covered call by the distance from underlying price to the strike price written. Well, sort of...

The limiting factor is that the underlying can only fall to zero whereas it can rise significantly more than that. Many quote that potential rise as unlimited but practically speaking, no stock has ever gone to infinity. Realistically, the naked call has upside less risk than a covered call until the amount of price rise is equal to the underlying's price plus the distance to strike. Since words are often not as clear as numbers, consider an example:

XYZ is $20. Compare selling a $25 covered call for $1 with just selling that call naked. The covered call loses $19 if it goes to zero, a drop of 20 points. The naked $25 call doesn't lose 19 points until the underlying hits $45 or 25 points higher. Within that price range, which is riskier? For equidistant moves in either direction, the covered call is riskier. However, above 45 it's a different story.

There are other factors to be considered such as the market rising for longer periods than falling but those are decisions as to which strategy is more appropriate for the market you're in. In the narrow confines of equidistant price movement in either direction, a naked call is less risky than a covered call.

If you really want to be clever, use vertical spreads instead of a B/W or a naked call, eliminating the bulk of the potential loss in either direction :->)

Answer 3

A covered call risks the disparity between the purchase price and the potential forced or "called" sale price less the premium received. So buy a stock for $10.00 believing it will drop you or not rise above $14.00 for a given period of days. You sell a call for a $1.00 agreeing to sell your stock for $14.00 and your wrong...the stock rises and at 14.00 or above during the option period the person who paid you the $1.00 premium gets the stock for a net effective price of $15.00. You have a gain of 5$. Your hypothecated loss is unlimited in that the stock could go to $1mil a share. That loss is an opportunity loss you still had a modest profit in actual $.

The naked call is a different beast. you get the 1.00 in commission to sell a stock you don't own but must pay for that right. so lets say you net .75 in commission per share after your sell the option. as long as the stock trades below $14.00 during the period of the option you sold your golden. It rises above the strike price you must now buy that stock at market to fill the order when the counter party choses to exercise the option which results in a REAL loss of 100% of the stocks market price less the .75 a share you made.

in the scenarios a 1000 shares that for up $30.00 a share over the strike price make you $5,000 in a covered call and lose you $29,250 in a naked call.Naked calls are speculative. Covered calls are strategic.

Answer 4

There is unlimited risk in taking a naked call option position. The only risk in taking a covered call position is that you will be required to sell your shares for less than the going market price.

I don't entirely agree with the accepted answer given here. You would not lose the amount you paid to buy the shares.

Naked Call Option

Suppose take a naked call option position by selling a call option. Since there is no limit on how high the price of the underlying share can go, you can be forced to either buy back the option at a very high price, or, in the case that the option is exercised, you can be force. to buy the underlying shares at a very high price and then sell them to the option holder at a very low price.

For example, suppose you sell an Apple call option with a strike price of $100 at a premium of $2.50, and for this you receive a payment of $250.

Now, if the price of Apple skyrockets to, say, $1000, then you would either have to buy back the option for about $90,000 = 100 x ($1000-$100), or, if the holder exercised the option, then you would need to buy 100 Apple shares at the market price of $1000 per share, costing you $100,000, and then sell them to the option holder at the strike price of $100 for $10,000 = 100 x $100. In either case, you would show a loss of $90,000 on the share transaction, which would be slightly offset by a $250 credit for the premium you received selling the call. There is no limit on the potential loss since there is no limit on how high the underlying share price can go.

Covered Call Option

Consider now the case of a covered call option. Since you hold the underlying shares, any loss you make on the option position would be "covered" by the profit you make on the underlying shares.

Again, suppose you own 100 Apple shares and sell a call option with a strike price of $100 at a premium of $2.50 to earn a payment of $250.

If the price of Apple skyrockets to $1000, then there are again two possible scenarios. One, you buy back the option at a premium of about $900 costing you $90,000. In order to cover this cost you would then sell your 100 Apple shares at the market price of $1000 per share to realise $100,000 = 100 x $1000. On the other hand, if your option is exercised, then you would deliver your 100 Apple shares to the option holder at the contracted strike price of $100 per share, thus receiving just $10,000 = 100 x $100. The only "loss" is that you have had to sell your shares for much less than the market price.