Sometimes options contracts help you reduce the risk in your portfolio. For example, buying puts is a simple way to insure yourself if you need to off-load a losing stock. Buying calls can limit your exposure if you think a stock's price will rise, but you don't want to take on the risk of actually investing in the stock.
But sometimes options are used for pure speculation. The contracts are so risky that they're more gambling device than investment strategy. Selling naked calls is the riskiest strategy of all. In exchange for limited potential gain, you assume unlimited potential losses. Here's what makes them so risky.
Why are naked calls so dangerous?
First, a quick overview of the two basic types of options contracts:
- Call options: Give you the right, but not the obligation, to buy a security for a certain price before the contract's expiration date. You'd buy them if you were bullish about a stock. You'd sell them if you were bearish.
- Put options: Give you the right, but not the obligation, to sell a security for a certain price before the contract's expiration date. You'd buy them if you were bearish about a stock. You'd sell them if you were bullish.
If you're writing (that is, selling) calls, you could write a covered call, which means you own the underlying stock. Or you could write a naked call, which means you don't own it.
Writing naked calls may sound appealing when you want to speculate on a stock's price and your near-term outlook is neutral to bearish. You can profit without ever owning the underlying stock if your prediction proves correct.
But naked calls are incredibly risky because your potential losses are unlimited. Theoretically, a stock's value could shoot to infinity and you're obligated to deliver it to the buyer no matter how high the market price climbs should they exercise the option. Meanwhile, your potential profit is limited to the income you received from the premium.
Limited upside vs. unlimited downside
Here's an example: Suppose you sold naked calls giving someone the right to buy XYZ stock from you for $60 a share. The $60 here is what's known as the strike price. For entering into this agreement, you receive a premium of $3 per share. Options contracts typically give investors the right to buy or sell 100 shares, so in this case, you receive $300.
In your best-case scenario, the stock's value stays the same or drops, and the contract expires worthless. You pocket $300 minus any commission for your brokerage firm. But suppose the stock's value doubles for some reason and the buyer exercises the option. It would be bad enough if you'd written a covered call because you'd have to sell your winning stock well below market price. But since you wrote a naked call, you could ultimately be forced to buy XYZ stock for $120 a share, and then sell it for $60. Your potential loss on the transaction is $6,000 -- all for $300 of premium income.
Of course, this scenario is unlikely. But if you regularly write naked calls, all it takes is one prediction gone awry to wipe out your profits from a dozen contracts that expired worthless.
Because of the unlimited potential loss, not just anyone can write naked calls. Brokers typically have substantial margin requirements and often only allow you to sell naked if you're an investor with a high net worth.
Is there a way to reduce the risk?
If you want to write call options, the best way to lessen the risk is not to go naked in the first place. Sticking with covered positions is obviously the safer bet.
As with any investment, the only way to lower the risk will also lower the reward. By writing naked calls with a short time until expiration, there's less time for the stock to make dramatic movements. Choosing higher strike prices lowers your risk as well. But of course since the buyer of the call wants to lock in the right to buy for the lowest price possible, increasing the strike price reduces the value of the call option, which lowers your premium.
Options trading in general is only appropriate for people with investment experience. But naked calls are seldom worth it given the infinite potential downside, even for investors with deep enough pockets to stomach big losses.
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