Selling Uncovered Calls
When call selling is reviewed in isolation, it is indeed a high-risk strategy. If you sell a call but you do not own 100 shares of the underlying stock, the option is classified as a naked option or uncovered option. You are exposing yourself to an unlimited risk. In fact, call selling in this situation is one of the most risky strategies you could take, containing high potential for losses. A buyer's risks are limited to the premium cost; depending on how many points a stock moves up, a call seller's losses can be much higher.
When you take a short position in a call, the decision to exercise belongs to the buyer.
ExampleUnacceptable Risks: You sell a call for 5 with a striking price of 45 and expiration month of April. At the time, the underlying stock has a market value of $44 per share. You do not own 100 shares of the underlying stock. The day after your order is placed, your brokerage firm deposits $500 into your account (less fees). However, before expiration, the underlying stock's market price soars to $71 per share and your call is exercised. You will lose $2,100âthe current market value of 100 shares, $7,100; less the striking price value, $4,500; less the $500 premium you received at the time you sold the call:
|Current market value, 100 shares||$7,100|
|Less striking price||-4,500|
|Less call premium||-500|
Smart Investor TipSelling uncovered calls is a high-risk strategy, because in theory, a stock's price could rise indefinitely. Every point rise in the stock above striking price is $100 more out of the call seller's pocket.
You will not be allowed to write an unlimited number of naked calls. The potential losses, both to you and to the brokerage firm, place natural limits on this activity. Everyone who wants to sell calls is required to sign a document acknowledging the risks and stating that they understand those risks. In part, this statement includes the following:
Special Statement for Uncovered Option Writers
There are special risks associated with uncovered option writing that expose the investor to potentially significant loss. Therefore, this type of strategy may not be suitable for all customers approved for options transactions.
- The potential loss of uncovered call writing is unlimited. The writer of an uncovered call is in an extremely risky position, and may incur large losses if the value of the underlying instrument increases above the exercise price.
- As with writing uncovered calls, the risk of writing uncovered put options is substantial. The writer of an uncovered put option bears a risk of loss if the value of the underlying instrument declines below the exercise price. Such loss could be substantial if there is a significant decline in the value of the underlying instrument.
- Uncovered option writing is thus suitable only for the knowledgeable investor who understands the risks, has the financial capacity and willingness to incur potentially substantial losses, and has sufficient liquid assets to meet applicable margin requirements. In this regard, if the value of the underlying instrument moves against an uncovered writer's options position, the investor's broker may request significant additional margin payments. If an investor does not make such margin payments, the broker may liquidate stock or options positions in the investor's account, with little or no prior notice in accordance with the investor's margin agreement.
The requirement that your portfolio include stocks, cash, and other securities in order to sell calls is one form of margin requirement imposed by your broker. Such requirements apply not only to option transactions, but also to short selling of stock or, more commonly, to the purchase of securities using funds borrowed from the brokerage firm.
When you enter into an opening sale transaction, you are referred to as a writer. Call writers (sellers) hope that the value of the underlying stock will remain at or below the striking price of the call. If that occurs, then the call will expire worthless and the writer's profits will be made from declining time value (as well as any decline in intrinsic value resulting from the stock's price moving from above the striking price, down to or below the striking price). For the writer, the breakeven price is the striking price plus the number of points received for selling the call.
ExampleGains Offsetting Losses: You sell a call for 5 with a striking price of 40. Your breakeven is $45 per share (before considering trading costs). Upon exercise, you would be required to deliver 100 shares at the striking price of 40; as long as the stock's current market value is at $45 per share or below, you will not have a loss, even upon exercise, since you received $500 in premium when you sold the call.
|Current market value, 100 shares||$4,200|
|Less striking price||-4,000|
|Loss on the stock||$-200|
|Option premium received||$500|
|Profit before trading costs||$300|
Smart Investor TipExercise does not necessarily mean you lose. The call premium discounts a minimal loss because it is yours to keep, even after exercise.
- The stock's value falls. As a result, time value and intrinsic value, if any, fall as well. The call's premium value is lower, so it is possible to close the position at a profit.
- The stock's value remains unchanged, but the option's premium value falls due to loss of time value. The call's premium value falls and the position can be closed through purchase, at a profit.
- The option's premium value remains unchanged because the underlying stock's market value rises. Declining time value is replaced with intrinsic value. The position can be closed at no profit or loss, to avoid exercise.
- The underlying stock's market value rises enough so that exercise is likely. The position can be closed at a loss to avoid exercise, potentially at greater levels of loss.
ExampleTaking Profits to Escape Risk: You sold a call two months ago for 3. The underlying stock's market value has remained below the striking price without much price movement. Time value has fallen and the option is now worth 1. You have a choice: You can buy the call and close the position, taking a profit of $200; or you can wait for expiration, hoping to keep the entire premium as a profit. This choice exposes you to risk between the decision point and expiration; in the event the stock's market price moves above striking price, intrinsic value could wipe out the profit and lead to exercise. Purchasing to close when the profit is available ensures that profit and enables you to avoid further exposure to risk. If the stock does rise, your breakeven price is three points higher than striking price, since you were paid 3 for selling the call.
ExampleGoing Naked, More than Just Embarrassing: You sold a naked call last week that had four months to go until expiration. You were not worried about exercise. However, as of today, the stock has risen above the striking price and your call is in the money. Your brokerage firm has advised that your call was exercised. You are required to deliver 100 shares of the underlying stock at the striking price. Your call no longer exists.
You can never predict early exercise, since buyer and seller are not matched one-to-one. The selection is random. The Options Clearing Corporation (OCC) acts as buyer to every seller, and as seller to every buyer. This ensures a liquid market even when one side of the transaction is much larger than the other. When a buyer decides to exercise a call, the order is assigned at random to a seller, or on the basis of first-in, first-out. You will not know that this has happened to you until your broker gets in touch to inform you of the exercise. In-the-money options are automatically exercised by the OCC on exercise date.
Smart Investor TipBecause exercise can happen at any time your call is in the money, you need to be aware of your exposure; early exercise is always a possibility. If you sell an in-the-money call, exercise could happen quickly, even on the same day.
- Its market value must remain at or below the striking price of the call, waiting out the evaporation of time value. The option will expire worthless, or it can be closed with a purchase amount lower than the initial sales price.
- The market value must remain at a stable enough price so that the option can be purchased below initial sales price, even if it is in the money. The decline in time value still occurs, even when accompanied by consistent levels of intrinsic value.
The profit and loss zones for uncovered calls are summarized in Figure below. Because you receive cash for selling a call, the breakeven price is higher than the striking price. In this illustration, a call was sold for 5; hence, breakeven is five points higher than striking price. (This example does not take into account the transaction fees.) To enter into a naked call position, you will need to work with your brokerage firm to meet its requirements.
[caption id="attachment_12483" align="aligncenter" width="380"] An uncovered call's profit and loss zones.[/caption]