5.1.7.1 Naked and Covered Options
Naked and covered calls. When an investor is long a security, it means that the investor owns the security. When an investor owns the underlying security and decides to sell a call option on it, the option is called a covered call. If the option buyer were to exercise the option and ask for delivery, the call writer already owns the security and does not have to cough up additional money to buy it in the market.
Example: John owns 100 shares of WXYZ, but wants to earn some extra income. John writes a call option on WXYZ with a strike price of $40 and pockets a $2 premium. The holder of the call decides to exercise the call when the stock price hits $45. John delivers his 100 shares to the buyer of the call and receives $4,000 (100 shares x $40 per share strike price).
When the investor does not own the security 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 considerable cash to buy the shares in the market and deliver them to the holder of the call at the strike price. With any written call option, the risks are enormous. The writer of a naked call has the added risk of not being financially able to meet her contractual obligations.
Example: Stacy wants to earn some extra income, so she writes 10 uncovered calls on WXYZ at a $3 premium and $45 strike. WXYZ is at $40 when she writes the calls and Stacy does not expect the stock to go up in price. She takes in $3,000 in premiums ($3 x 100 shares x 10 calls). Unfortunately, shortly after she writes the call, WXYZ comes out with a phenomenal earnings report and their stock skyrockets to $70 per share. All 10 of her calls are exercised. Because Stacy doesn’t own the stock, she will have to buy the shares in the market at $70 to deliv