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.

You need to be able and willing to deliver 100 shares in the event that the call is exercised, no matter how high current market value has gone. If you do not already own 100 shares, you will be required upon exercise to buy 100 shares at current market value and deliver them at the striking price of the call. The difference in these prices could be significant.

When a call is exercised and you do not own 100 shares of the underlying stock, you are required to deliver those 100 shares at the striking price. This means you have to buy the shares at current market value, no matter how high that price. Because upward price movement, in theory at least, is unlimited, your risk in selling the call is unlimited as well.
The risks of selling calls in this manner are extreme. With that in mind, a brokerage firm will allow you to sell calls only if you meet specific requirements. These include having enough equity in your portfolio to provide protection in the event of an unusually high loss. The brokerage firm will want to be able to sell other securities in your account to pay for losses if you cannot come up with the cash. You will need approval in advance from your brokerage firm before you will be allowed to sell calls. Each firm is required to ensure that you understand the risks involved, that you fully understand the options market, and that you have adequate equity and income to undertake those risks.

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.

1. 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.
2. 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.
3. 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.
It is possible to write a call and make a profit upon exercise. Given the preceding example, if the call were exercised when the stock's market price was $42, you would gain $300 before trading costs:

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

As a writer, you do not have to wait out expiration; you have another choice. You can close out your short position at any time by purchasing the call. You open the position with a sale and close it with a purchase. There are four events that could cause you to close out a short position in your call:

1. 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.
2. 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.
3. 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.
4. 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.

Whenever you sell a call and you do not also own 100 shares of stock, your risk is described as a naked position, which refers to the continuous exposure to risk from the moment of sale through to expiration. Remember, the buyer can exercise at any time, and exercise can happen at any time that your naked call is in the money. Even though exercise is most likely at the time just before expiration, there is no guarantee that it will not happen before that time.
In this example, you experience a loss on the stock because you are required to purchase 100 shares at current market value and deliver them at the striking price. Even so, you may have an overall profit if the gap between current market value and striking price is less than the amount you received when you sold the call.

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.
In order to profit from selling calls, you will need the underlying stock to act in one of two ways:

1. 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.
2. 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]

Potential loss in call writing is conceivably unlimited because no one knows how high a stock's price could rise. Put writers, in comparison, face a limited form of potential loss. The maximum is the difference between the striking price and zero; in practical terms, the real risk level is the difference between striking price and tangible book value per share.