You may be wondering what uncovered calls are and what possible strategies one can employ to profit from uncovered call writing. To be honest writing uncovered calls can hardly be called a strategy as the risks involved are far greater than the profit the writer could possibly make. However, it is not entirely impossible to benefit from uncovered call writing in the same way as it is not entirely impossible to benefit from shorting stocks. Before I begin my discussion let me just warn you that if you are thinking of writing an uncovered call you might want to re-evaluate and re-assess the possible risks that are involved. What does uncovered call writing mean? Uncovered call writing means that an investor writes or creates a call stock option wherein he does not own the underlying stock that is the subject matter of the call option. This is also called a naked call. To help you understand how uncovered call writing works, I have prepared a short illustration. Note, however, that for purposes of simplicity, tax considerations, commissions as well as transaction costs have been omitted in my illustrations. Also, the call options here are assumed to be American style, which means that the call option can be exercised any time before the expiration period.
The main objective of this strategy is to profit from the premium that the holder will pay for the call option without actually paying for the expenses of buying the underlying stock. The writer must, however, deposit and continue to sustain a margin with his broker so as to insure that the stocks can be delivered in case the call option is exercised. The downside may easily be guessed such as if the holder of the option exercises the option and the stock prices have significantly increases. This and other questions will be tackled in the illustration.
Let us assume that you write an uncovered Stock C July 65 call option and you received premium for $6 per share for a total of $600 for 100 shares of Stock C. This means that for $600 you are obligated to sell 100 shares of Stock C for $65 per share. Assuming that the stock prices of Stock fluctuates but never goes beyond $65 per share. This means that there is no to little chance that the call option will be exercised. You get to go home with the $600. But what if the stock prices go beyond $65 per share and actually reach the $75 per share mark. The call option may be exercised and you may be forced to buy 100 shares of Stock C for $75 and re-sell it for $65 each. That would yield you a loss of $1,000 ($7,500 – $6, 500). This loss is mitigated by the $600 premium thereby reducing your loss to a total of $400. One can see that one of the disadvantages of uncovered call writing is that you are exposing yourself to unlimited losses as the stock price increases. This loss, however, can be mitigated by the premium paid to you, and/or by purchasing the underlying stock thereby becoming a covered call writer. As with any call option you can also make a closing purchase transaction any time before your call option expires. Writing uncovered calls may be profitable in times of stable or declining stock prices.