Let’s start off with a brief reminder of what we’re talking about: options are derivative contracts that offer traders the right, but not the obligation, to buy (call) or sell (put) an underlying asset at a specific price before or when the option expires.
Short call options strategies
The driving idea behind call options, whether covered or naked, is the same: the trader placing them hopes to profit if an asset’s price declines. Tactically, though, the motivation for using one or the other is different.
The main distinction is between speculating and hedging. The naked call options writer (i.e. seller) simply thinks the price is going to go down and wants to make money from a short bet on the underlying asset. The covered call writer, by contrast, is aiming to earn a small income from or hedge a long position.
Of course, all options writing involves some amount of speculation about what the price will do. Even if hedging, the reason for taking out the hedge is a belief that the asset you own could go down temporarily. The difference comes down to intent: covered calls are like taking out insurance, naked calls are like betting on horse races.
Covered call option strategy
A covered call is when an options trader writes (sells) a call option in the same underlying asset that they have an ownership position in. When they write an option, they receive the premium from the buyer as their income on the trade. The trader can use their position in the underlying asset as a kind of collateral to “cover” the options trade in case the buyer wants to exercise their call option.
Objective:
The options trader, in this instance, is looking to add some extra income (the premium) from an options trade on top of their long position in the underlying. In other words, the option is “covered” by assets they possess.
The ideal outcome for someone using a covered call strategy is twofold: firstly that their position in the underlying increases to somewhere over the long-term price. At the same time, they hope that the underlying market goes down or sideways in the time between writing the call and its expiry date.
Risk:
The adverse scenario for the covered call options trader is that the option they wrote trades above the strike price, because then they must deliver the agreed amount of the underlying asset to the option buyer at that price. They will have to sell their shares (or commodity, or forex pair, etc.) at less than the current market price. Note that European-style options can only be exercised on the expiry date, while American-style contracts are valid at any time up to their expiration.
Payoff diagram
The below represents what the profit and loss the covered call options writer can expect to make, depending on movements in the asset price relative to the premium they received.
Source: quora.com
Covered call example:
An options trader owns 100 shares of Apple stock (AAPL) and decides to sell a call option with a strike price $50 above the current market price and expiration in 30 days. They would receive a premium of $5 per share. This is called an out-of-the-money (OTM) option because it has no intrinsic value because it cannot be exercised at the present time.
If AAPL falls or goes up by less than $50, then the options trader earns the premium and the option expires worthless. Moreover, in the case AAPL stock rises but not above the strike price, the options trader takes a net profit of the premium while their shares are also worth more. In case it falls, the premium has offset some of the loss in the underlying long position.
If AAPL rises by more than $50, then the buyer will exercise their call option and the covered call option trader would have to sell the shares at the strike price, losing the difference of $50 per share in unrealised profit. Clearly, the size of the premium is determined by the probability of the strike price being reached.
Naked call option strategy
A naked call option, sometimes called “uncovered” or “unsecured”, is the opposite in that the trader who writes one does not own the underlying asset. As described above, the covered call option trader is writing a call option that is covered by an underlying long position. In essence, the trader owns the stock they are offering to sell in the call options contract.
The naked call option strategy involves writing a call option on a market that the trader has no underlying position in. Put another way, the naked option seller does not own what they are offering to sell.
Objective
A naked call options strategy is a relatively aggressive and risky one. The idea is much less about adding income to or hedging an existing position. Naked calls are more of an outright speculation that an asset will go down in value. Put another way, the naked call option trader wants the same outcome as the one writing covered call options: for the underlying asset to stay the same value or fall. However, they are taking on more risk in the process.
Risk
The naked call options trader can take a significant loss if the underlying asset moves above the strike price. If this happens, they must buy the asset on the open market and then sell it to the call option buyer at the (lower) strike price. The options writer will have lost the full difference between the market price and the strike price.
In a sense, the naked call option writer is more confident of their bearish position in the market, much like the buyer of a put option. The key difference is that the naked call option holds theoretically unlimited risk because the price can go up infinitely, whereas the put buyer has capped their risk by the size of the premium that they paid for the put option.
Payoff diagram
The diagram below represents the profit and loss the naked call options writer can expect to make relative to the premium they received.
Naked call example
An American options trader owns no euros but nonetheless decides to write (sell) a call options contract in EUR/USD with a strike price at the current forex market price, which expires in 60 days. They are therefore selling an at-the-money (ATM) option, where the strike price and spot exchange rate are equal. They receive a premium of 50 pips.
If EUR/USD stays the same or falls in value, the naked call option writer will keep their premium with no loss. If EUR/USD moves higher by any amount, the options buyer will exercise their call option, though the naked seller will only lose money when the difference between the strike price and the market price exceeds the value of the premium they received. If the price increase is greater than 50 pips, of course, the naked call writer has lost the difference.
