Writing Naked Call Options

What do you mean by naked option, covering stock, writing an option ?

We will discuss options in great detail later in the semester. However, it is sufficient to note that the essence of a call option is that the purchase of a call option gives you get the right to buy the stock underlying the option at a fixed price on or before a given date. For example, the IBM 90 call option having a Jan 04 expiration gives you the right to buy IBM at $90 a share any time prior to the third Friday in January 2004. If the stock price is at $120, exercising your option permits you to buy the stock at $90. If IBM is at $89.75 in Jan 04, you simply let your option expire worthless. So your loss from buying a call option (or a put option for that matter) is limited to what you pay for it.

Where does the option come from?? Who issues it?? The answer is that you cannot buy a call option (or a put option) unless another investor is willing to sell you the call option. That is, a call option is a bet between two anonymous individual investors, with one investor being required to pay for the gain that the other investor recieves from the option trade. Many investors write (sell) covered call options against stock that they own as a meeans of generating extra income (we will discuss whether this is a smart move later on). For example, I own some IBM stock that I have written (sold) the January 04 100 call options against. The terminology in the preceeding sentence implies that I own 100 (or more) shares of IBM stock and have sold to another investor the right to buy my IBM shares at a fixed price on or before January 16, 2004. The call option permits its owner to buy my IBM shares at $100 if they want ---but of course the exercise is their option and they certainly don't have to buy my stock if its value is at $50 a share--they just walk away and let their options expire. If IBM is at $120 or even $180 a share next January, I will have to sell my stock to the investor who owns the options at a price of $100. The terminology "writing/selling a covered option" refers to the fact that writer/seller of the call is covered against a major loss by owning stock that can be delivered if the option that was sold (written) is exercised.

Do you have to own the underlying stock to write a call option?? Absolutely not, so long as you satisfy the special margin requirements necessary to write options and you have of course met the investor suitability standards of your broker. Selling an call option on a stock that you don't own is called writing a naked option in that you have no protection if the stock price rises dramatically (i.e., you are not covered against a loss on the option by owning share of the underlying stock that you can deliver to the option holder). Imagine the plight of an investor who sold a call option to buy Yahoo at $45 per share as he watched the price of Yahoo rise to $400 per share. To add insult to injury, if a 'naked write' goes badly for you, your broker adds insult to injury when the option is exercised against you by buying stock for you to deliver against the exercise and charging a commission. When this happens to me, it is almost impossible for Allan the broker to conceal his joy in making a full service commission when he buys the stock that I have to deliver to the owner of the naked call option. Sure, Allan is a little sad that I lost money, since he knows that the loss means that I will have less money to trade with in the future. But any pain that Allan feels as a result of my loss disappears as he takes his cut of yet another full service commission.

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