Introduction To Writing Naked Out Of The Money Calls
A naked out of the money calls strategy involves the shorting of out of the money calls without owning the underlying security in the hope that the calls expires worthless. When the calls expire worthless, the trader collects premium which is otherwise known as the maximum profit of the strategy. It is notable that out of the money options have a higher probability of expiring worthless.
As long as conditions are neutral to slightly bearish, the calls will expire worthless. This occurs specifically when the price of the underlying security is less than or equal to the exercise(strike) price of the written call on the expiration date of the option.
Writing OTM naked calls will result in a net credit.
Read more : What does “net credit” mean in options trading?
Margin requirement for writing naked calls
Margin is required when writing naked out of the money calls. The amount of margin required is subject to broker’s discretion.
Step 1 : Perform economic, fundamental and technical analysis
Before writing naked calls, the options trader must perform economic, fundamental and technical analysis to ascertain that the general direction of the markets and the underlying security is down. Fundamental analysis will tell the trader if the underlying security is trading at fair value. In depth technical analysis will help a trader to find optimal exit and entry points along the charts. Some of the chart patterns that option trader should look out for before writing a naked OTM call are:
For more read : Basic economic analysis , Basic fundamental analysis , Introduction to technical analysis.
Step 2 : Outlook – Slightly Bearish
A trader that executes the naked out of the money calls strategy is predicting stagnant or slightly bearish conditions of the underlying security.
Step 3 :Study the option chain
Examine the options chain. Select an option with a strike price that is above the current trading price of the underlying security.
Step 4 : Breakeven Analysis
There is only 1 breakeven point in the naked call writing strategy.
Breakeven price = Exercise price of call + Option premium
At this price point, there is neither profit nor loss. There is only 1 breakeven point.
Step 5: Understand Your Profit Zones
The breakeven price point has been calculated at this point. The options trader should know that the profit zone of the naked OTM call which is written is to the left of the breakeven point.
Step 6 : Potential for unlimited loss
When the price of the underlying security moves above the exercise(strike) price of the call option. The call moves from being out of the money to being in the money. Since in the money options are worth more, the trader who chooses to buy to close at this point will incur a loss. The greater the price increase, the greater the loss of the trader. The loss is potentially unlimited because the price of the underlying security can theoretically go up to infinity.
Step 7 : Loss calculation
The loss can be calculated as:
Trading price of the underlying security – exercise price of short call – premiums received from writing OTM calls + commissions paid to broker
Step 8 : Profit
The profit is attainable when the price of the underlying security is less than or equal to the exercise(strike) price of the shorted call. On expiry, when the above condition is met, the calls expire worthless and the trader gets to keep the premium collected.
Step 9 : Profit calculation
The maximum profit is calculated as:
Premiums collected – commissions paid
Step 10 : Calculate Risk & Reward Ratio
The maximum reward is the premium collected(net credit) from writing the naked call. However, there is a potential for an unlimited loss. Hence, the trader should put in place stop losses at certain prices that will force him to exit the trade. Once that has been done, it is wise to calculate the risk and reward ratio. Doing so will help a trader to compare one trade to another of a similar nature, on a risk and reward basis.
Read : Understanding Risk/Reward Ratio For Option Traders
Step 11 : Set Up Trade
Write naked OTM calls through your broker or through an electronic trading account.
Step 12 : Exit Trade & Record Trade In Diary
After the trade has been exited, it would be wise for the trader to record the trade in a diary for review, reflection and analysis.
Example Of Writing OTM calls
The price of PPP Corp is trading at a price of $47. A trader writes a December 50 out of the money call can collects a premium of $200. By the expiration date of the option, PPP was trading at at $55. The call option has moved from out of the money to in the money. The intrinsic value of the call option is now $55 – $50 = $5
The loss is:
($5 – $2) x 100 = $300
When the price of PPP Corp trades at $47 or less, the option expires worthless as it is out of the money. In this case, the premium of $200 belongs to the trader.
If conditions of a stagnating or slightly bearish price persists, the trader can choose to write another out of the money call to collect premium. This can be done so regularly as long as conditions of stagnation and slight bearishness persists.
Writing OTM calls vs ITM calls
Writing OTM calls will increase the probability of the options expiring worthless as compared to writing ITM calls.
Covered Puts Vs Naked OTM calls
The covered put has a similar payoff profile to that of writing naked out of the money calls.
Read more here : Execute A Covered put : Short underlying security & write puts
Read also : Writing Naked in the money calls to collect premium : A bearish options strategy