If you own shares, you can put a call option with coverage. This strategy is known as a Covered Call.
But what if you don’t have the right stock to cover an option?
In this case, you can use the strategy of writing an option without coverage, i.e. A naked call that can be interesting if you can manage risks well.
This strategy is gaining popularity among investors as the volatility of the stock market increases. High volatility also means higher option premiums, which attract option writers.
This article takes a look at this strategy. We will show you what an open call option writing is and when it is applied.
What does it mean writing an option without cover?
The call option is used when we want – as a writer – to sell a stock (or other asset) at a price higher than the current price.
Before we go into further explanation, it should be noted that there are significant risks involved in writing an empty call option. This is a much more risky strategy than writing a buy option with coverage.
How big is this risk? It depends on you.
Writing an option empty is one of the simplest strategies. There is no combination of options here, you just write (sell) the options at a specified strike price on a specified expiry date.
The figure below shows an example of a call option written. In this case, only one transaction is performed:
Sale of call options with a strike price of $ 40, for which you received a bonus of $ 1
Strategy to issue a call option without cover
In the example above, we can see that we are getting an option premium of $ 1, which pushes our break-even point to $ 41. If the price of the underlying is above this price on the option expiry date, the position will be lost.
This loss is potentially unlimited. In theory, the underlying instrument can reach an infinitely high price. Of course, this is just a theory. Nothing rises to an infinitely high price. In any case, this is the greatest risk associated with this strategy. There may be times for the market to skyrocket unexpectedly and the option writer is forced to sell the stock at a very unfavorable price relative to the market.
From the figure above, you can see that the $ 100 option premium received is the writer’s maximum potential profit. This is achievable if the share price on the expiry date is below $ 40.
This option strategy is a credit strategy, which means we get the option premium and a positive theta. Time passes in favor of the writer, as the option being sold loses value over time, even if the price of the underlying instrument does not change or rises slightly (below the break-even point). The drop in the price of the underlying instrument also works in favor of the option writer. There is therefore one negative scenario for this strategy and it is a sharp upward movement of the underlying instrument’s price.
What are the benefits of writing a call option without cover?
What are the disadvantages of writing an open call option?
Maximum profit is limited
Unlimited loss possibilities
High deposit requirements in relation to profit
How do I choose the expiry date and the strike price?
If you put a call option, you get an option premium. Ideally, the price of the underlying of a written call option will decline and the option will become worthless over time until its expiry date. In this case, the received option premium is the profit. This is the main reason why naked call options are issued.
Determination of the exercise price
First, let’s look at the strike price. If you are writing an option, the first thing you should want to do is write it at a strike price that will make the option out-of-money. Such options have no intrinsic value, only a time value that fades with each passing day. Over time, the option premium decreases even though the value of the underlying has not changed or increases slightly.
However, it should be remembered that when choosing the strike price, you should pay attention to the amount of the option premium you will receive. Options with too high a strike price will also have a small bonus, so listing them isn’t even profitable. So choose a strike price that is far enough from the market price but still offers a decent premium and thus a decent potential profit.
Specification of the expiry date
As for the expiry date, we can be more precise here. If you are writing a call option without coverage, do not choose an expiry period longer than 3 months. The shorter the duration of the option, the faster the theta is lost.
However, attention should be paid to the amount of the bonus. You won’t get much for a buy option with an exercise date next day. You should choose options with an expiry date of 3 to 6 weeks. These options offer a reasonable premium and will depreciate fairly quickly over time. This is what you want.
See also: Greek delta, gamma, vega and theta coefficients
Rollover of written call options
If you’ve guessed the market correctly, the call option you issued is worthless and you don’t need to worry about anything – the option premium is all yours.
However, it may happen that we are not on the right side of the market and the put call option expires in-the-money. In this case, the option writer has the option to postpone the call option expiry date to the following month, otherwise he will have to take a short position in a market whose price is higher than the entry price and will suffer a loss immediately.
You can roll over an option to a higher strike price and get a premium similar to the current option. The current option you are buying back has virtually no time value as the expiry date is near. However, it has intrinsic value because it is in-the-money.
As you roll over the option and then put out a new one with an expiry date of several weeks, this newly issued option will have a time value. This allows you to roll over until the newly issued option is worthless at the expiry date.
Writing of an option without cover in practice
Has the share price risen and its further upward movement seems unlikely?
In such a case, writing a call option may constitute actual speculation.
Writing a call option is useful if you expect the price to stay still or even slightly increase.
The example below shows Microsoft Corporation (MSFT) stocks. We anticipate that the share price will not rise sharply, but will stay the same or fall, possibly rising slightly. In such a case, the discussed “naked call”, ie writing a call option, may be a good strategy.
We are looking for a call option with an expiry date of July 15, 2022 at an exercise price of 270 USD. We can see that for such an option, we would have received an option premium of $ 2.90. The current price of the MSFT stock is $ 260.44.
The break even price is therefore $ 272.9 (the strike price plus the amount of the bonus received). As the written option loses its value over time, even if the share price remains steady or slightly increases, the position taken is still profitable. When it finally expires worthless, the entire option premium ($ 290) is our profit.
Sending a call option can be a very profitable strategy, but as mentioned at the beginning, there is a risk involved. It should be remembered that in the event of unfavorable market developments, it is possible to roll over options or accept a loss.
We will continue to discuss option strategies, and in the meantime, you can watch one of our option webinars in the archive.
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