What it is:
How it works (Example):
In a naked call strategy, the sale of a call option is predicated on the writing party's belief that the market price of the underlying security will not exceed the specified strike price prior to the expiration date. For this reason, the call option is sold "naked" without the underlying units. Logic follows that, as long as the market price of the underlying security remains below the strike price, the writer profits from the contract premium received.
To illustrate, suppose an investor, Bob, believes strongly that the price of stock XYZ will not exceed $100 in the market. In an effort to generate a profit, Bob engages in a naked call by writing a call option on, but not physically comprising, 100 shares of XYZ with a strike price of $100 and an expiration date of 31 December 2009. Bob sells the contract for a $1,000 premium, all of which he will be able to retain as profit provided that the market price of stock XYZ remains below $100 per share through 31 December 2009.
Why it Matters:
A naked call provides options investors with the opportunity to generate a profit without having to own the physical units associated with the underlying security. The writing party bears the risk of having to provide the specified units of the underlying security in the event that the market price rises above the contract's specified strike price in the buyer's favor. For this reason, investors who choose to engage in naked calls must ensure that they are in a position to provide the associated units prior to the sale of the contract.