4.1.7.3. Naked and Covered Options
Naked and covered calls. When an investor is long a futures contract or other asset, it means that the investor owns the asset. When an investor owns a futures contract and decides to sell a call option on it, the option is called a covered call. If the option buyer exercises the option and asks for delivery, the call writer already owns the asset (or the futures contract) and does not have to cough up additional money to buy it in the market.
Example: John buys a December T-note futures contract at 124’0. Not expecting much price movement on his contract, he decides to cover his futures contract by writing a call option to generate revenue. He considers two out-of-the-money calls: a Dec 126 call @ 2’32 and a Dec 128 call @ 1’16. With his futures contract not expected to move sharply, he selects the call with the lower strike price. This offers the higher premium at the expense of downside protection. At 2 32/64 points, John pockets $2,500 (2.50 x $1,000). Should prices remain stable and the call stay out of the money, he will be able to hold onto the premium and keep the futures contract. If the price of the futures contract goes above 126 and the holder of the call option decides to exercise it, John can deliver his futures contract.
When the investor does not own the futures contract and writes a call option, it is called a naked call. It is a naked call because the investor has sold something she doesn’t own and is vulnerable to the market. If the price of the security goes through the roof and the call is exercised, she will have to come up with enough cash to buy the futures contract in the market and deliver it to the holder of the call. With any writte