Understand What is Naked Call Writing

6 mins read

The more exclusive something is, the more people want it. And so it is with Naked Calls, that brokers tend to encourage (or even allow) only out of experienced traders or traders that are able to put up substantial margins with your broker.

The tussle between the lure of exclusivity and tremendous risk

Being exclusive, everyone wants to know what Naked Call Writing is; many traders even want to trade Naked Calls without even knowing what they are, only because Naked Calls are often allowed only for the top brass of traders by way of experience and margins.

This should not be surprising because human nature is such: We have all witnessed the long lines outside discotheques that are exclusive about permitting entry to patrons. And the world’s fashionable folk witnessed how a luxury brand selling a certain type of overpriced handbag exclusively to patrons able to prove their “worthiness” by spending top dollar regularly, drove up the demand for the said bag, rather than driving it down.

This is largely why the average trader, and even the beginner trader, is keen to know what Naked Call Writing is. We’re going to break the concept down for you – in simple layman’s terms – as we do in all our articles, but unlike otherwise, we’re going to start with a few words of caution:

Naked call writing comes with risks that many beginner traders might not be able to fathom (and we will attempt to explain the risks as we progress), but suffice to say that the quantum of risk is indefinite. There is absolutely no cap on the risk that one might experience. It is almost like having a bet with someone and saying that if they lose they pay you Rs 100 and if you lose, they can ask for anything. You have no idea what you’ll be paying to make good on your end of the deal.

Of course, if you know exactly how to play it, you might just be able to walk away with earnings. It’s just that the risk is higher than in most other types of trading maneuvers.

What exactly is a Naked Call?

Just like the bet above, where you don’t know what your input cost will be, in a Naked Call, the trader does not know exactly what his input cost will be.

In a Naked Call, one writes an option to sell shares at a certain price (the strike price) by a certain date (the expiry date) and until here, everything is like any other call option, but in a Naked Call Option, the trader agrees to sell shares that he does not own.

The price of the shares could rise to just about anything and if the contract is exercised and the share price rises far beyond the strike price, then the Naked Call Writer will have to buy at possibly exorbitant prices in order to make good on their deal to sell at the strike price.

Example and working of Naked Call Writing

Varun writes a Naked Call Option where he agrees to sell 100 shares at Rs 200 per share. The premium is Rs 3 and therefore Varun earns Rs 300 (Rs 3 premium x 100 shares) for writing the contract. That’s Rs 300 in Varun’s pocket. Score, Varun! The current price of the shares on the market is Rs 205. Varun expects that the share price will drop.

Scenario 1: The share price – as Varun had expected, drops to Rs 200. Varun buys and sells the shares and walks away with earnings by way of the Rs 300 premium he had earned. This is what one might call a fairly positive outcome

Scenario 2: The share price drops to Rs 198 and the contract buyer decides he is better off buying the shares on the open market rather than paying Varun more for them. He does not exercise his option to buy and the contract expires. Once again Varun retains the Rs 300 made by way of his premium earnings. This is what one might call a desirable outcome, or one that many traders are going for.

Scenario 3: Varun’s prediction emerges as entirely wrong. When the expiration date comes, the share price is Rs 500. The buyer of the contract exercises his option to buy (because who wouldn’t want to buy at Rs 200 when the market price is Rs 500) and now Varun is left with no choice but to sell. He has to buy shares for Rs 500 in order to sell them at Rs 300 and therefore undergoes a huge loss of Rs 300 per share multiplied by 100 shares. His loss is Rs 30,000. And it could have ended up even higher because a share price has the potential to rise infinitely.

Risk management measures in Naked Options Writing

Smart traders will usually try to offset the potential losses that could emerge from the fact that the stock price can rise indefinitely. There are two commonly used means of doing this:

  1. Buy shares of the same company when the price is lower than the strike price

The trader may want to buy shares first and then write the naked call options contract such that the strike price is higher than what he paid. This might involve some waiting and watching, but it has the ability to improve his chances of earning and reduce his chances of losses.

  1. Buy a call option for the same company’s stock

The trader can also buy a call option for the same stock. That way, the trader is able to fix the price he would have to pay for the stock in order to make good on his deal. It would be the equivalent of you having a bet with someone and telling them that if you win, you get Rs 100 and if they win they can ask for anything (as discussed at the beginning of the article), but adding the clause that the value of ‘anything’ will need to be less than Rs 100, for example.

Conclusion

There is indefinite risk in Naked Call Writing because one commits to sell at a certain price when there is no guarantee of what stock prices will rise to. As a result, the strategy is often practiced by experienced traders and is always supported by well-calculated risk management measures such as holding the same stock or buying a call option for the same stock.