In finance, options are contracts that convey they right, but not the obligation, to sell a stock at a certain price at a certain time. A call option is purchased as a way to potentially profit from a rise in the price of a stock above a certain level. The seller of the option can sell it in two different ways, commonly called naked and covered. A covered option means that the investor who is selling the option owns the underlying stock. A naked call option, also known simply as a naked call, is more speculative and risky, because the seller does not own the underlying stock, and is therefore exposed to theoretically unlimited loss.
A naked call and a covered call have more in common than not, but it is the one big difference between them that is the source of the risk. For any call option, the seller does not believe that the price of the stock or other instrument will rise above a certain level, called the strike price, in the near future. The buyer of the option disagrees, and plans to make a profit if he’s right.
For example, if a share of XYZ stock is currently trading for $10 US Dollars (USD) per share, an investor might sell a call option with a strike price of $12 USD. This is, in effect, a statement by the seller that he does not believe the price will rise above $12 USD. When the investor sells the option, the buyer pays him a premium for each share represented in the contract.
The buyer is putting money on his hunch that the price of the stock will rise above $12 USD. If it were to do so, and rise to $13 USD, for example, he still has the right to buy it for $12 USD. If he does, he can immediately resell the stock for a profit. Alternatively, he can also sell the option to someone else, and it will sell for more than he paid for it in this case, creating another profit center for the investor. These principles apply to all call options.
A naked call means that the seller of the option does not own the shares of XYZ stock, and if the option is exercised, the seller is forced to buy the shares and then immediately sell them at a loss. The amount of the loss is the amount by which the current market price exceeds the strike price. If the strike price on XYZ was $12 USD, and the current price is $15 USD, the seller loses the entire $15 USD per share, since he never owned the stock in the first place. A covered call, on the other hand, would only cost the seller $3 USD per share in losses. It is easy to see through this example why the use of a naked call is best suited to more sophisticated investors with a high tolerance for risk.