Introduction To Writing In The Money Naked Calls
Writing an in the money naked call involves shorting in the money calls with the projection that the price of the underlying security moves below the exercise(strike) price of the call option within the remaining lifespan of the call option. When that happens, the call options moves from in the money to out of the money and the option premium reduces in price. The trader can proceed to buy to close the calls and hence, earn a profit. The word “naked” refers to not having a position in the underlying security.
Usually, writing in the money naked calls involve shorting deep in the money calls because deep in the money calls have greater intrinsic value.
Net Credit
Writing naked in the money calls will result in a net credit.
Margin requirements
Writing naked in the money calls are a very risky strategy and hence, margin requirements will be more stringent as compared to other strategies. For more about this, consult your selected broker.
Read more : What does “net credit” mean in options trading?
Steps
Step 1 : Perform economic, fundamental and technical analysis
Step 2 : Outlook – Bearish
Step 3 : Study the option chain
Step 4 : Breakeven Analysis
Step 5: Understand Your Profit Zones
Step 6 : Potential for unlimited loss
Step 7 : Loss calculation
Step 8 : Limited potential profit
Step 9 : Profit calculation
Step 10 : Calculate Risk & Reward Ratio
Step 11 : Set Up Trade
Step 12 : Exit Trade & Record Trade In Diary
Step 1 : Perform economic, fundamental and technical analysis
The options trader should first perform economic analysis to assess the general direction of the markets. Next, the options trader should assess the underlying security using fundamental analysis. Last but not least, with technical analysis, the options trader is able to determine optimal entry and exit points. Some chart patterns that the options trader should look out for are:
Read : Basic Economic Analysis , Basic fundamental Analysis and Introduction to technical analysis
Step 2 : Outlook – Bearish
Writing in the money calls is a bearish strategy. The trader who writes in the money calls expects the price of the underlying security to decrease. When that happens, the price of the call options reduce and a trader can close out the trade at a profit.
Step 3 :Study the option chain
The options trader should examine the options chain next and select the options to be used in the strategy.
Step 4 : Breakeven Analysis
The breakeven price point is calculated as:
Exercise price of the call shorted + premiums collected
The breakeven price point is the price of the underlying security at which there is neither profit or loss.
Step 5: Understand Your Profit Zones
After the calculation of the breakeven point, the trader will understand where the profit zone is. The profit zone is to the left of the breakeven point.
Step 6 : Potential for unlimited loss
The potential for losses are unlimited because the price of the underlying security go theoretically go up infinitely. Since writing in the money naked calls are a bearish strategy, this strategy starts to go wrong when the price of the underlying security goes up. When the option is far deeper in the money than it was before, the trader will make a loss when the trade is closed out.
A loss occurs when the sum of the premiums collected from writing the in the money naked calls is and the exercise(strike) price of the call is less than the trading price of the underlying security.
Step 7 : Loss calculation
The loss can be calculated as :
Trading price of the underlying security – exercise price of the short call – premiums collected + commissions paid to the broker
Step 8 : Limited potential profit
The rationale for writing in the money calls is to collect higher premiums. Option premiums are greater for in the money call options than out of the money options. When the price of the underlying security decreases, the calls may expire worthless or reduce in price. If the options expire worthless, the trader collects the maximum profit which is equal to the premiums collected. If the options reduce in price, the trader can buy to close the trade and still earn a profit.
Step 9 : Profit calculation
The maximum profit can be calculated as:
Premiums collected – commissions paid to broker
The maximum profit occurs when the call option expires worthless. The call option expires worthless when the price of the underlying security is less than or equal to the exercise(strike) price of the call option shorted.
Step 10 : Calculate Risk & Reward Ratio
With stop losses in place, the options trader should calculate the risk reward ratio. This will determine the attractiveness of the strategy on a risk and reward basis.
Read : Understanding Risk/Reward Ratio For Option Traders
Step 11 : Set Up Trade
Once the option has been selected based on strike price and expiration date, the trader can proceed to write naked ITM call, that is, execute the trade through his broker.
Step 12 : Exit Trade & Record Trade In Diary
After the trade has been exited, the trade’s performance should be recorded in a diary for review, reflection and analysis. Doing so will help the trader to sharpen his or her trading skills.
Example A Naked In The Money Call
PQR Corp is trading at a price of $37. A trader who is bearish on the stock decides to write a January $30 call without owning the underlying security. By writing the naked call at $9, the trader collects $900 in premiums. When the price of the underlying security is trading at $50 at expiry, the shorted call is assigned and the trader is obliged to buy 100 shares in the open market at a price of $50 and sell it the call buyer at a price of $30. The loss is thus:
(($50 – $30) – $9) x 100 = $1100
If the price trades at $20, the trader will earn a profit when the options expire worthless. The options expire worthless because the price of PQR is less than the exercise(strike) price of the shorted call. Hence, the maximum profit is equal to premiums of $900 collected.
The breakeven is calculated as:
$30 + $9 = $39
When the underlying security price trades at $39 on the expiration date of the call option, the call option will have an intrinsic value of $900. Since $900 was the premiums collected when the call option was shorted, there is no loss or profit when the trade is closed out.
Covered put vs Writing ITM naked calls
The covered put is a comparable strategy to writing ITM naked calls.
Read : Execute A Covered put : Short underlying security & write puts