The Naked Call: Not for Novices

A naked call occurs when you write or sell a call option by itself. It’s termed "naked call" because of the unlimited downside risk. You can also buy a call that has a limited risk; you would risk only the price of the call itself. The naked call you sell, however, can easily become a huge liability in your brokerage account. Here are some factors to keep in mind before choosing this trading strategy.

Delta

The delta of the call is important because it measures the price sensitivity to the underlying investment vehicle that the call is based on. Since the delta ranges from -1 to 1, the delta will fall between those two numbers. Let’s imagine, for example, we decide to trade a naked call that has a delta of 0.80 and we sell the option; that means the delta is actually -0.80. In other words, for every point the underlying security goes up, our naked call will lose 80 percent of the value that the underlying security gained. Since we sold the option, the account can go negative, which would mean that we owe more money than the actual premium collected at the outset.

Implied Volatility

The volatility in the market is unpredictable, but since options are derivatives based on the change in value of the market, volatility is the prime factor in pricing options. Therefore, the greater the volatility, the greater the prices of the options will be. From another perspective, options will be more expensive if the volatility goes up dramatically. A good time to sell a naked call is when the volatility is high and there is an expectation for a dramatic decrease in volatility. Note that implied volatility is different from historical volatility experienced in the markets. Historical volatility is the actual volatility experienced in the markets, whereas implied volatility is the expected future volatility that is priced in the options markets. Statistical tools can help decipher when options' prices are cheap or expensive based on these two statistical measures: historical volatility and implied volatility.

Holding Period

Since the nature of naked calls is the most risky type of trading in options, the holding period must be short. In addition, the time until expiration is also a key factor. Typically, naked options should not be held for more than a couple of weeks.

Theta

The theta of the call is important because it measures the price sensitivity of the option in relation to the expiration of time as the option reaches its date of expiration. The theta value can be positive, but most of the time it is negative, given that the option loses its time value as it approaches expiration. The greater the negative theta, the more the option will lose value per day held. The best options to choose from are those that expire within the next month or sooner. All else being equal, one should choose the call that has the highest negative theta value.

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