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"In business and finance, a naked call refers to a trading strategy or options contract in which an investor sells a call option on a security without owning the underlying asset."
What is Naked Call?
A naked call is considered "naked" because the seller of the call option does not hold a long position in the underlying asset that could be used to fulfill the obligation if the buyer exercises the option. Instead, the seller hopes that the option will expire worthless or can be bought back at a lower price before expiration, allowing them to keep the premium received from selling the option.
The strategy of selling naked calls can be attractive to investors seeking income or to profit from a belief that the price of the underlying asset will remain below the strike price, resulting in the call option expiring worthless. By selling the option, the investor receives the premium upfront, but they are exposed to potentially unlimited risk if the price of the underlying asset rises significantly.
It's important to note that selling naked calls carries significant risks and is generally considered a high-risk strategy. If the price of the underlying asset increases above the strike price, the call option buyer may exercise the option, forcing the seller to deliver the underlying asset at the strike price. The seller would then have to purchase the asset at the prevailing market price to fulfill their obligation, resulting in a substantial loss if the price has risen significantly.
Regulatory authorities often impose certain requirements and restrictions on selling naked calls to protect investors and ensure market stability. Margin requirements, for example, may be imposed to ensure that sellers have sufficient funds or collateral to cover potential losses if the option is exercised.
It's crucial for investors considering the use of naked calls to fully understand the risks involved and to have a comprehensive understanding of options trading strategies. It is generally recommended for inexperienced investors to seek professional advice or utilize more conservative strategies that align with their risk tolerance and investment objectives.
In summary, a naked call in business refers to the selling of a call option on an underlying asset without owning the asset itself. It involves significant risk as the seller is exposed to potentially unlimited losses if the price of the underlying asset rises above the strike price. Investors should exercise caution and consider their risk tolerance and knowledge of options trading before engaging in naked call strategies.
Example of Naked Call:
Let's consider an example of a naked call with numbers to illustrate the scenario.
Suppose that Company XYZ is trading at $50 per share, and you believe that the stock price will remain below $55 over the next month. You decide to sell a naked call option on Company XYZ with a strike price of $55 and an expiration date in one month. The premium you receive for selling the option is $2 per share.
By selling the naked call, you are obligated to sell Company XYZ shares at the strike price of $55 if the buyer of the option decides to exercise it. However, since you don't own the shares, you are exposed to potential risk if the stock price increases significantly.
Scenario 1: Stock Price Remains Below the Strike Price
If the stock price of Company XYZ remains below $55 until the option expiration, the call option will expire worthless. As the seller, you get to keep the premium of $2 per share as profit. In this case, you have successfully executed the naked call strategy and generated income without having to deliver any shares.
Scenario 2: Stock Price Rises Above the Strike Price
However, if the stock price of Company XYZ rises above $55 before the option expiration, the buyer of the call option may choose to exercise it. Let's say the stock price rises to $60 per share. The buyer has the right to buy the shares from you at the strike price of $55, even though the market price is higher.
In this scenario, you would need to purchase the shares at the market price of $60 per share to fulfill your obligation to the buyer. As a result, you would incur a loss of $5 per share ($60 market price - $55 strike price). Since each option contract typically represents 100 shares, the total loss would be $500 per contract (100 shares x $5 loss).
This example highlights the risk of selling naked calls. If the stock price continues to rise, your losses can be significant and potentially unlimited. It's essential to assess the market conditions, evaluate the potential risks, and have a clear strategy in place before engaging in naked call options.
It's important to note that options’ trading involves complexities and risks, and this example is for illustrative purposes only. It is always recommended to consult with a qualified financial advisor or professional before engaging in options trading strategies.