In-The-Money Naked Call

[Igor 10]

Traders who implement an in-the-money naked call strategy are betting that the market price of an option's underlying asset will fall. The technique involves selling an in-the-money call option, hoping that it will expire out-of-the money. Traders who employ this type of bear option strategy do not need cash to enter the market. However, the terms of their call sale will limit their profit potential. On the contrary, an investor's loss potential is infinite. If the market price rallies, traders who use this strategy will incur large monetary losses.

 

Moneyness Review for Calls

 

Out-of-The Money (OTM) = Strike price (more than) Market Price

In-The-Money (ITM) = Strike price (less than) Market Price

At-The-Money (ATM) Strike price (equals) Market Price

 

How to Carry Out An In-The-Money Naked Call Strategy

 

 

Disney stock is worth $48 (market price) in June.

1) Trader sells the call option: DISJul40($10)

- 100 shares of Disney stock

- Strike Price $40, in-the-money (ATM), expiring in 30 days

- Premium Cost of $10

2) Trader receives a $1000 credit when entering the market [$1000 (received from call buyer)]

Total cost to enter the market: -$1000

 

Result one: Disney stock rises (rallies) to $68 in July

a) The call option sold expires ITM, and the investor who bought the trader's call option exercises his or her right to buy 100 shares at $40.

b) The trader purchases 100 Disney shares in the open market to cover the short sale, paying $6800, and then sells the shares to the buyer, receiving $4000.

c) The trader loses a total of $1800 after subtracting the premium credit taken when entering the market. [-$1800 = $1000 (credit to enter market) - $2800 (loss from call)]

 

Result two: Disney stock falls (moderately) to $45 in July.

a) The call option sold expires ITM, and the investor who bought the trader's call option exercises his or her right to buy 100 shares at $40.

b) The trader purchases 100 Disney shares in the open market to cover the short sale, paying $4500, and then sells the shares to the buyer, receiving $4000.

c) The trader's profit totals $500 after subtracting the loss from premium credit taken when entering the market. [$500 = $1000 (credit to enter market) - $500 (loss from call)]

 

Result three: Disney stock falls (crashes) to $28 in July.

a) The call option sold expires worthless (OTM).

b) The trader's profits totals $1000 after keeping the credit earned when entering the market.

Advantages and Disadvantages in Carrying Out An In-The-Money Naked Call Strategy

 

Pluses: The upside to this type of strategy is that investors do not need cash to enter the market. They are betting that the asset's market value will crash and the call will expire OTM, allowing them to keep the credit earned when entering the market. Traders can also use the credit to gain a profit in moderate bull markets or to offset losses if the underlying asset's value rallies.

 

Minuses: The downside in using an in-the-money naked call strategy is that it exposes traders to high-risk losses when the market rallies, since any asset's market price could theoretically rise as much as demand permits. The method also limits the trader's profit potential to only what he or she received when entering the market.

Edited May 17, 2012 by Igor