What Are Naked Calls
And Why Are They So Risky?

What are naked calls? The answer is important to know - not so that you can learn to set up this option trade. But so that you know why you never should.

Naked Calls vs Covered Calls

Although both call options are considered to be short options, the difference between naked calls and covered calls couldn't be more stark.

In a covered call situation (check out this link for covered call examples), someone is essentially paying you up front for the right to buy your shares (underlying stock) at a set price (strike price) by a set date (expiration date). Now, obviously, someone would only exercise those rights if it were in their best interest to do so - specifically when the share price is higher than the strike price (which would make the call option "in the money").

This is a fairly conservative trade - the premium you receive for selling the call is real income for you and it acts as a limited downside hedge (i.e. it can be seen as an unofficial reduction of your cost basis).

And if the stock makes a big move higher, the only risk or downside to you is that, depending on where you set the strike price, you'll miss out on some, most, or all of those capital gains (be sure to read this page on the best strike price for covered calls if you're interested in more details).

In short, if the stock rockets higher after you've written a covered call, although you've definitely limited your profits, you'll never actually lose money on the trade.

If the same scenario takes place with a naked call, however, the complete opposite is true.

If you promise to sell somebody something at a certain price without owning it in the first place, it's only a matter of time before you'll really regret that decision. If they ever show up to collect it, you're going to be forced to buy it yourself (higher) on the open market before you can sell it to them (lower) at the agreed upon strike price. And that's a recipe for disaster.

Naked Call Examples or Hi, I'm Crazy and I Write Uncovered Calls

How about some examples to illustrate why selling uncovered calls is so risky?

For a powerful illustration consider this simple, short list of real world examples:

AMZN - $95 Short Call

• 10/22/2009 Closing Price = $93.45 ($1.55 out of the money)
• 10/23/2009 Closing Price = $118.49 ($13.49 in the money)

NTFLX - $52.50 Short Call

• 1/27/2010 Closing Price = $50.97 ($1.53 out of the money)
• 1/28/2010 Closing Price = $63.04 ($10.54 in the money)

POT - $115 Short Call

• 8/16/2010 Closing Price = $112.07 ($2.97 out of the money)
• 8/17/2010 Closing Price = $143.17 ($28.17 in the money)

So you see, it's not just small biotech firms where you can see a huge spike in the price overnight. So much so that you could take what would've been a winning trade as a covered call and instantly turn it into a $1000, $2000, $3000 loss.