In a recent article on Google (NASDAQ/GOOG), I reviewed the merits of employing a simple put option strategy for bearish investors or those who want to establish a hedge against downside weakness.
Some option traders try to generate premium income vis-à-vis the writing of naked calls. But as will become apparent, the risk-reward trade-off is inferior to that of put options.
Simply, when writing naked calls, it means you write or sell a call without actually holding the underlying instrument, whether stocks, futures or bonds.
Versus a Covered Call, writing naked calls means the option written is not hedged with an underlying long position.
It is this uncovered or exposed nature of Naked Calls that makes the trade an extremely risky proposition. For instance, should the market price of the underlying instrument decline below the strike price of the call, you would retain the premium for writing the call.
On the other hand, should the market price surge, you could be vulnerable to potentially large losses if the option is exercised. Why? Assume the call option is exercised. As the writer, you would be required to enter the market, buy the underlying instrument at the higher market price and then deliver it to the holder of the call option at the lower strike price.
For example, let's examine the Google "out-of-the-money" June $350 calls, with the stock trading at $346.48 (March 15). In exchange for assuming the risk for writing a Naked Call on this particular option, you would receive a premium of $28.50 per share or $2,850 per contract ($28.50 x 100 shares). This premium represents the maximum reward from this trade.
Now let’s assume that the price of Google surges back to $400 and the holder of the call option decide to exercise. Under this scenario, the loss to you would be $2,150 per contract ($400 - $350 - $28.50 x 100 shares). At $500, the loss would be $12,150.
In theory, the market price of Google could rise to infinity hence, the upside risk is unlimited. In reality, the loss is constrained by the use of internal risk control measures such as margin calls. For instance, as Google rises in price, you would be subject to ongoing margin calls. In most cases, the position would be closed and the account settled. This limits the loss.
As evidenced, the loss from writing Naked Calls could be substantial and not worth the potential maximum reward, which in this case is the $2,850 premium per contract. In my view, the premium fails to compensate for the risk assumed.
The breakeven point occurs when the market price of the stock surpasses the strike price by the amount of the premium. In our example, the breakeven price (excluding commissions) would be $378.50 per share ($350 strike + $28.50 premium).
The example we used is only for illustration purchases and not intended to be a recommendation or actual strategy. Because options are inherently risky, we recommend speaking with an options specialist before considering a strategy.
George Leong is the founder of www.investornomics.com - a provider of independent stock and option trading commentary. He has a degree in finance/economics and offers over 15 years of research experience in investing and trading.
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