Dangers of selling naked calls

Many people start selling naked calls in the stock market before they fully analysis the risk that it involves.  This is a big mistake.

Many people start selling naked calls in the stock market before they fully analysis the risk that it involves.  This is a big mistake.

                To understand what a naked call is you should first understand what a call is.  When you buy a call what you actually do is buy the right to buy a given stock at a given price on or before a given date.  For this you would pay a fee. 

                When you sell a naked call you are trying to capitalize on that fee they pay.  You can actually sell a call even if you do not have that stock to offer.   So say you sell the $45 call on a stock that is trading at $41 for $3.

                You would make $3 initially.  But you are obligated, until the option expires, to buy the stock at whatever price it is trading for and sell it for $45.  If the stock does not go above $45 you walk away with $3.That sounds pretty good doesn’t it?  As long as this stock does not go up 10% in the near future you can still make money.  

                What some people fail to realize is that your max loss is infinite.  If the stock goes up to $46 you have to buy it at $46 and sell it at $45.  You lose $1 here, not bad considering you made $3.  But what If the stock goes up to $80 or $90, or higher?  That can seriously hurt you, and maybe bankrupt you if you sold enough shares.

                Because there is no limit to how high a stock can go you are risking an infinite amount of money to make $3.  That is not exactly a great idea. 

                There is a great way to lessen your loss, however.  This is done by turning the naked call trade into a bear call spread.   Let us look at the example above.  We sold the $45 put for $3. This time we also bought the $50 put for $1.5. 

                Now we lessened our gain to $1.5, but also lessened our loss.  If the stock goes up to $80 it doesn’t matter.  We can buy it at $50 and sell it at $45 giving us a $5 loss instead of a $35 loss.   Much better.

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