Risk Exposure When Writing Call Options

The risk exposure when writing call options is the single biggest consideration you need to make before investing capital. Depending on whether you are pursuing a covered call writing program or a naked call writing strategy, the risks of writing calls involve a significant amount of risk. While the exposure in each of these cases is different, understanding each difference is a critical part of the process. For the sake of ease, we will focus on equity call options, but the same principles apply to other types of underlying securities.

Covered Call Writing Programs

When you write or sell an option on a stock that you already own, the call is considered covered. This is because should the option be exercised, thus requiring you to deliver the shares of the stock to the owner of the option, you will already own the shares; you do not need to go to the open market and purchase the shares at the current market price.

Calls are most frequently exercised when the price of the stock appreciates dramatically in a short period of time and near expiration (otherwise the owner is better off selling the option and recapturing a portion of the time value). Generally, the risk in being short a call is that the price of the stock will appreciate, so if you already own the stock, that risk is mitigated (you are covered) because you will profit on the stock position as it rises, even while losing on the option position.

Therefore, the risk exposure on a covered call is in terms of the lost upside you get if the stock appreciates, although the risk on the overall position (the option and stock combined) is the exposure to the stock at a cost basis lower by the amount of premium received for the option.

Naked Call Writing

When you write a naked call option, you do not own the underlying stock and your risk is significantly higher. This is a less capital-intensive (there is no capital allocation to owning the stock) and higher yielding approach if it is successful; the premium that is captured is pure profit because there is no additional position against which the profit is measured. The risk, however, that you take on in this approach is unlimited.

If you do not already own the stock, you will not be offsetting loses as the stock’s price rises. Instead, when the option is exercised, you will have to go to the open market and buy the stock at the current, and now much higher, market price. Because in theory the price can rise without limit, you risk exposure is also without limit. This is why many brokers do not allow any but their most experienced customers to write naked calls.

While the profit on naked calls tends to be higher than on covered calls when the strategy is successful, the unlimited risk feature of this strategy means that you should be very confident and comfortable with the worst-case scenario before pursuing this approach.

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