Bearfoot Calls
The CallWriter Technique For Writing (Nearly) Naked Calls
By John Brasher, CallWriter.com Publisher

If you've read the CallWriter special report on writing naked call options, you've learned that writing naked calls is like stealing money out of the market. Big premiums, no cash investment required, great monthly income! But there's a catch... naked calls are risky, and brokerage firms have very stiff requirements for writing naked calls, so stiff that most investors aren't allowed to write naked. Darn! But CallWriter can show you a technique that lets you write (nearly) naked calls.

CallWriter "Bears" it all...

We call them "Bearfoot Calls" and they're incredibly profitable, low risk and easy to do. Want to know how? Read on!

A Quick Primer on Call Options
The CALL is a stock option in which the call seller (the writer) agrees to SELL a specified number of shares of a particular stock (the underlying stock) at a specified price (strike price) by a specified date (the expiration date) in the event the call is exercised. The CALL entitles the holder (buyer) to buy some or all of the stock at the fixed price through the expiration date. In other words, he can exercise all his calls, or just some of them. Call options are bought and sold much the same as stock; the seller receives the bid price, and the buyer pays the asked price. The price paid or received when a stock option changes hands is the premium. You cannot buy or sell a call option on a single share, since each option contract covers 100 shares. So to write calls on 1,200 shares of ORCL, for example, you would have to write 12 call contracts. When you write a call, you are said to be short the calls, and the buyer of the calls is said to be long the calls. Calls are naked when the call writer doesn't own the underlying shares of stock, and they are covered if the stock is owned. Writing naked calls brings in a limited return (the premium received) but involves high risk, since the price of the underlying stock theoretically could go to infinity... and if the calls are exercised, the naked call writer faces a loss by having to go into the market and buy the stock needed to meet the delivery requirement.

Those Pesky Brokerage Requirements
Because they are so magnificently profitable, you knew there had to be a catch to writing naked calls, and there are several. First, because the risk is theoretically unlimited, brokerage firms severely limit who can write naked calls and how they are written. Second, only investors with an option account approved for Level 4 or 5 options trading (sometimes Level 6) can write a naked call. Third, most firms require that your options trading account be of a certain minimum size, ranging from $50,000 to $100,000. Fourth, no margin is allowed, so if you wrote naked calls on 1,000 shares of CSCO when CSCO is at $15, you would have to have the $15,000 in your account in liquid form and it would be reserved (set aside) to cover the naked calls written, in addition to the account requirement. Some firms do not allow naked call writes at all. If you have to wonder whether you are permitted to write naked calls, the answer almost certainly is NO.

There's Naked, Covered and "Bearfoot"
Naked calls are simple: you just write calls. Covered calls also are simple: you write the calls and simultaneously buy the underlying stock in order to cover the calls, which is kind of expensive. But suppose you could write naked calls for big, fat premiums and cover them another way, without having to buy the stock and tie up your capital? There is a way to do it! CallWriter calls it the Bearfoot Calls technique. Why the name? Well, it's not naked but not totally covered, either - it's like going barefoot. And because the calls are written on stocks that are expected to go down or at least not go up meaningfully, the trade has a bearish to neutral orientation. Get it? Bearfoot. We know it sounds corny, but Bearfoot Calls work like a charm. Bearfoot Calls are a great investment tool, and here's why:

• Requires no investment of your cash - you get paid to create it
• Bearfoot Calls are simple to understand, quick and easy to create
• Create Bearfoot Calls for a great income every month
• Risk is limited and can be closely managed (and often mitigated)
• Brokerage firms will actually let you run Bearfoot Calls trades
• You don't need stock movement to profit - you win even if it doesn't move

So How are Bearfoot Calls Created?
Very simple, you write the call you want, which should be slightly out of the money (OTM). Simultaneously, you buy a higher strike call on the same stock, which will be much cheaper than the short call because it is much further OTM. It's easy to remember:

• Write the (more expensive) lower strike call
• Buy the (cheaper) higher strike call

     Sell the low, buy the high - a bear strategy, for sure.  For instance, when the stock is $14.25, you could sell the 15 call and buy the 17.50 call, which creates a call spread. The "spread" is the $2.50 difference between the 15 and 17.50 strikes. You pocket the difference between the premium received for the short call and the cost of the long call, which is known as the trade's "net credit." Both calls must have the same expiration, and the number of short and long calls must be the same and have the same underlying stock (duh). The technical term for this trade is a bear call spread, because it is created using call options, and it profits if the stock holds price or declines, which is a neutral to bearish orientation. It is a credit spread, because the trade generates a net credit into your pocket. Because it is a spread, the total risk is the net spread (spread - net credit received). Because the two calls' strike prices are not the same, it is considered a vertical spread. Keep reading, though, Bearfoot Calls are much simpler than they sound...

Example 1:  Let's look at an example involving Rambus Inc. (RMBS). In early March 2003, the stock is $13.52. There are two great possibilities for writing a Bearfoot Call. You could profit by writing the MAR 15 ($.45 bid) and buying the MAR 17.50 call ($.10 asked) for a net $.35 profit per share. Or if you don't mind being in the trade 4 weeks longer, write the APR 15 ($1.05 bid) and buy the APR 17.50 call ($.15 asked) for a net $.90 profit per share. The following table illustrates the Bearfoot Call strategy on RMBS:

Look what happened in this trade: the trader really only cared about selling the 15 Call and pocketing a fat premium. So he bought the 17.50 Call solely to limit his exposure in case the stock moved up - and so that his brokerage firm would allow the trade. The trader saw a fat enough net credit and a risk exposure that he liked.

Brokerage Firms Like Spreads
You call usually write spreads like the Bearfoot Call with a Level 2 or Level 3 options account. Why? Your total risk is the difference between the two strikes. If you write the $25 Call and buy the $30 Call, the spread between the strike prices is $5, and your loss can never exceed the $5 spread, as explained below. Many option brokerages - like optionsXpress - have order entry screens that are custom designed for each separate option strategy - and yes, they have a screen for a Bearfoot Call (bear call spread) trade. This means you can simply enter the two option transactions into the order screen and hit the submit button. If you have been writing covered calls, your brokerage firm likely will allow you to do Bearfoot Calls (bear call spread), but may want to see your account size increase... meaning to put more money in.

     Cash-Secured Trades.  Although your broker may have assigned you an option account approval level that doesn't permit the Bearfoot Call, when you have enough free cash (meaning cash that is not securing any trade) in your account to cover your trade risk on a Bearfoot Call, your broker frequently will allow the trade. This is known as a cash-secured spread. Doing cash-secured trades is not a problem or an inconvenience, but a smart tactic, since it enforces good discipline.

     Increase Trading, but Not Exposure.  Suppose you have $25,000 in your account and wanted to create the RMBS Bearfoot Call trade. You would do so by writing 10 of the RMBS April 15 calls above and buying 10 of the April 16.50 Calls. You put $900 in your pocket and are at risk for $1,600. To buy 1,000 shares of RMBS would have cost $13,520, over half the account value! If you bought the shares outright wouldn't you have $1,600 worth of risk? Of course you would. Actually, you would have $13,520 at risk! But you could write ten (10) Bearfoot Call trades identical to the RMBS trade and only have $16,000 (10 x $1,600) of your account capital at risk, while putting $9,000 in your jeans! Obviously, you would never find 10 stocks identical to RMBS on which to create Bearfoot Calls, but you see our point.

Bearfoot Call Risks
Unlike the naked call, in which there is no theoretical limit to the possible losses, your total risk on the Bearfoot Call spread trade is the net spread, which is the spread (difference between strikes) less the net credit you receive.

Bearfoot Call total risk = Higher strike price - lower strike price - net credit received

Example 2:  Suppose you create a Bearfoot Call by writing the $25 Call and buying the $30 Call for a net credit of $2; the spread is $5 - the difference between the $25 and $30 strikes. No matter what happens, your loss can never exceed $5. In fact, in this example your loss can't exceed $3 ($30 strike - $25 strike - $2 net credit). If the stock gaps up to $40, you will be called out on the $25 Call, but you own the $30 Call and can buy the stock at $30 to deliver it. If you wrote the $25 call naked, you would have to deliver the stock at $25 but would have to go into the market and buy it at $40, for a $15 loss. Ouch!

Example 3:  Going back to the RMBS Bearfoot Call trade in Example 1 above, suppose RMBS moves up to $18 at expiration? You will unquestionably be called out of the RMBS 15 Call, which means you will have to sell shares of RMBS at $15. You don't have to go into the market to buy the stock at the $18 market price, though, because your long 17.50 Call entitles you to buy the needed RMBS shares at $17.50. So no matter how badly you mis-read RMBS, your maximum risk is $2.15 for the March trade and $1.60 for the April trade. The chart below repeats the information in the first chart and adds the Risk computation.

	Sell $15 Call (lower strike)	Buy $17.50 Call (higher strike)	Net Credit	Risk (Net Spread)
MARCH Calls	$0.45	$0.10	$0.35	$2.15
APRIL Calls	$1.05	$0.15	$0.90	$1.60

Are Bearfoot Calls risk free? No, nothing in the market is. However, if you bought RMBS in the above example at $13.52 instead of creating a Bearfoot Call, would your risk profile be any better? Probably not, but buying 1,000 shares would cost you $13,520!

No Cash Investment Needed!
This is very important - - notice that the Bearfoot Call trade does not involve any outlay of your trading capital. It is a credit spread, which means that the only cash outlay is the trade costs, which slightly reduce your net credit. The Bearfoot Call puts a net credit in your pocket every time, because you always get more for the slightly out of the money (OTM) call you sell than the deep out of the money call you buy. Naked calls are highly risky, at least in theory, and covered calls require you to tie up precious capital in the underlying stock. The Bearfoot Call is the better bargain, since it limits risk, requires no cash investment and does not require you to tied up capital in the stock. Here are the two salient characteristics of the Bearfoot Call, which offers limited reward but limited risk:

1.  Your maximum return is the net credit.
2.  Your maximum risk is the net spread (the spread less the net credit).

     Monthly Income.  But that is not a problem. What the Bearfoot Call does is create a monthly return, a monthly income, without you having to tie up your cash buying the stock, like covered calls require (although as noted above you may have to cash-secure your broker in an amount equal to your exposure on the trade). Look at Example 3 above. If you wrote 10 RMBS 15 Calls and bought 10 RMBS 17.50 Calls, the net credit to you would be either $350 for the March spread, or $900 for the April spread.

Profile of Good Bearfoot Call Stocks
When you enter a stock or stock option trade, the stock can do only 1 of 3 possible things: go down, move sideways, or go up. In order to successfully write a Bearfoot Call, you want a stock carrying a high call premium that more likely than not will either:

* go down (bearish)
* not go up significantly (neutral)

What a deal! Buying calls, buying puts and many other strategies require that the stock move in one direction or the other, which gives you a 1 in 3 chance of winning. But the Bearfoot Call wins if the stock holds price or goes down, which is a 2 in 3 chance of winning - or 67%! If you are bullish on a stock, even moderately bullish, it is NOT a good Bearfoot Call candidate. While beyond the scope of this article, to determine likely stock direction, a combination of fundamental and technical analysis is required, and good charting is essential. Start with fat premium, then select the stock, then select the spread. More tips:

TIP 1: stocks carrying high premiums are volatile, period. The market considers the underlying stock to be more volatile than other stocks at the time, and that is why the premium is so high.

TIP 2: Premium be darned, it is not wise to write calls on stocks with earnings news or other significant news (for example, anticipated FDA ruling on a pending drug application) expected prior to expiration. Do your homework, please. Never write a call just because the premium is really high - - there is a reason the premium is high, and you'd better do your research to find out why.

TIP 3:  Don't create Bearfoot Calls on a stock approaching or hitting its support level, because it may bounce off and advance. Let it break support first. If a stock is rolling (moving sideways, or "channelling"), you are safer creating the Barefoot Calls at the top of the channel. Finally, when a stock has been falling, be aware of a possible retracement and make sure you have enough time before expiration for the retracement to occur and fade.

TIP 4:  Bearfoot Calls are iffy when the market is on a rally, even a bear rally, because a rising tide lifts all boats. (Don't worry, when the market is in an uptrend, we have a put spread strategy that also puts dough in your jeans.)

TIP 5:  Check out CallWriter's Real Time Lists™ of the highest returning calls. The ones with high premiums, little or no volume and little or no open interest potentially are good Bearfoot Call candidates, since the premiums are artificially high, not high due to trading demand.

Selecting the Call Strikes
It's great to say that you create a Bearfoot Call position by writing a call and buying a higher strike call. But which ones? Easy, go for the highest combination of fat premium and acceptable risk. We don't try to set rules or formulas very much, because risk tolerance varies so widely. Remember, what you really are doing in the Bearfoot Call is writing the call with the fattest premium that is not in the money. You are only writing the higher strike call to cap your risk exposure (and so your brokerage firm will let you do the trade). Let's look at this dynamic in a little more detail:

     Lower Strike Call:  The short strike (the strike of the call you sell) should be slightly out of the money (OTM). Ideally, the stock should be at least 2%-5% less than the strike price. So if the stock is $25, you want the stock no higher than $24.50, because you need some margin for error. Depending on your read of the stock, you might want it more than 5% below the short strike. Stocks frequently move either way (or even both ways) before expiration. Writing a slightly OTM call lets the stock move a few percent before expiration without stopping you out of the trade or triggering a cover. Leave yourself some room for stock movement before being forced to cover.

     Higher Strike Call:  The farther out of the money the higher strike is, the less it costs, so the bigger the net credit you pocket. However, the farther out the high strike is, the greater your risk. Go back to Example 2 above. Instead of writing the 25 Call and buying the 30 Call, assume you buy the 35 Call, which increases the total spread from $5 to $10. Assume also that this increases your net credit from $2 to $3, because the 35 Call is so cheap. You increased your return 50% (from $2 to $3), but doubled your exposure from a $5 spread to a $10 spread. It's your "call."

     Stay Out of the Money:  We think that writing an at-the money (ATM) strike is gambling, because it leaves so little room to react if the stock moves up. Writing an in-the-money (ITM )strike carries even greater risks, since if the stock does not fall below the short strike by expiration, you certainly will be called out of the stock. The only exception to this rule would be to construct a Bearfoot Call in which you received a huge premium for a deep-in-the-money (DITM) call and cover by purchasing a much cheaper at-the-money (ATM) call at a price that still leaves a fat net credit. This still will not eliminate trade risk, however, because the cost of the ATM call will be high enough to still leave some spread exposure.

Example 4:  When MSFT is $24.50 you write the 20 Call for $4.75, and you buy the 25 Call for $1.25. This trade yields you a net credit of $3.50 ($4.75 - $1.25). Your risk in the trade is $1.50, the difference between the $5 spread between the two strikes and the $3.50 credit received. However, if MSFT is above $20 at expiration you will be called out for sure and realize the $1.50 loss. After you assess the chances MSFT will drop to below $20 expiration, how good does that fat premium look? Not so good!

     Time Consideration:  Finally, because the Bearfoot Call depends on the short (lower) strike expiring worthless for maximum profitability, it is best to use calls with no more than 6 weeks remaining until expiration.

     Watch the Charts:  If the stock has been falling, watch out for a retracement in selecting your two strikes. If the stock is rolling and at or near the bottom of its channel, don't select a short strike too close to the channel's bottom, since its natural rolling action might move the stock above the short strike at expiration.

How the Bearfoot Call Wins and Loses
You must first understand that calls and puts are rarely exercised before expiration day. If you write the 25 Call and the stock goes to $30 a week before expiration, you might think the call's holder would exercise it right then, but you would be wrong. While early exercise could happen, it seldom does. Why not? First, the holder paid for the full option period. If the stock is advancing, the holder has until expiration to exercise it, so why pull the trigger early? It could go even higher in the time remaining until expiration. Second, most call holders don't exercise their calls, they sell them back into the market. If you paid $1.50 for the 25 Call and the underlying stock has moved up to $27, the 25 Call should be selling for $3.50 or more (its $2 intrinsic value plus ime value). So why bother exercising the call in this instance? It's just as easy and just as profitable to sell the call back into the market, for a $2 profit. And this is precisely what call holders do.

Conversely, if the call is in the money at expiration, you must figure it will be exercised. So if you write the 25 Call and the stock is $25.25 on expiration day, the chances are excellent that you will get an exercise. When an option is $0.75 or more in the money at expiration, the Options Clearing Corporation will automatically exercise it unless the holder has given contrary instructions, so you can bet on exercise in this circumstance. However, don't assume that your short call has to be that much in the money for you to get an exercise. With these pieces of information, now let's look at how the Bearfoot Call wins and loses. It's simple:

The Bearfoot call wins and makes the maximum return when the short call (lower-priced strike) expires worthless - because you aren't called out of the stock, and you keep the net credit that the trade generated for you.

The Bearfoot Call loses when the short call is in the money at expiration, meaning that the price of the underlying stock is higher than the short strike at expiration. The maximum loss you can sustain on the Bearfoot Call is the net spread - the spread minus the credit you pocketed, and the maximum loss occurs when the stock is above the long (high) strike at expiration. But keep in mind that the Bearfoot Call trade only loses if the short strike is exercised, whether it's in-the-money or not. As explained below, if the short call is exercised when the stock is above the short strike but below the long strike, you don't exercise the long call to cover, you simply go into the market to cover, and you still may have a loss (or even have a small profit), but less than the maximum loss.

Exiting the Bearfoot Call Trade

There are 4ways for the Bearfoot Call trade to end:

1.  Both calls expire worthless - and you simply keep the net credit.

2.  The short call is exercised and you cover at the higher strike - this yields the maximum loss.

3.  The short call is exercised, but you cover in the open market - yielding a smaller loss or small profit.The Bearfoot Call splits the difference when the stock at expiration is above the low strike (in which case you probably will get an exercise) but below the high strike. In this case, the trader will either have a small profit or have a loss that is less than the net spread.

Example 5:  The chart below goes back to Example 1 above, but in this chart, we assume that RMBS is $17 at expiration. As you can see the maximum possible loss (the net spread) was $2.15 for the March spread and $1.60 for the April spread. However, if the trader bought the stock at $17 to cover the short strike at expiration, he reduces the actual loss from $2.15 to $1.65 on the March spread, and from $1.60 to $1.10 on the April spread. It's a bad exit, but $0.50 less than the maximum possible loss when the trader entered the trade.

4.  The stock's price drops - and you close the Bearfoot Call position early by selling the long call and buying back the short call, for a good profit.

Example 6:  Suppose as in Example 1 you set up an April Bearfoot Call on RMBS when it is $13.52 by selling the 15 Call and buying the 17.50 call, for a net credit of $0.90. Then RMBS drops to $11. The asked price for the 15 Call you sold for $1.05 has dropped and you can repurchase it for $0.15, and the bid price on the 17.50 call you paid $0.15 for has dropped to $0.05 if you want to sell it. It makes sense to buy back the short call for $0.15, which still leaves you a net credit of $0.75, just because doing so terminates all trade risk and frees up your account for another trade. Don't bother selling the 17.50 Call, since the $0.05 bid price probably won't even pay for the trade.

Alternative: if you don't see the price of RMBS coming back, you can sit tight and wait for expiration, which leaves you with the maximum profit. Unlike the covered call writer, you can be sanguine about a big drop in the stock's price, because you don't own it.

When to Exit the Trade
As long as the stock remains below the short strike, you're in good shape. But when the stock price reaches the short strike, you should consider buying the stock to cover the short strike and selling the long strike. Prices will determine this tactic, of course. The less you pay for the stock to cover the short strike, the less profit you give up

Example 6:  Let's use Example 5 above, but instead of covering at $17, assume the trader covers the short strike immediately at $15.25 when the stock moves above the 15 short strike. Instead of a loss on the trade, he keeps a small profit on the March spread and $0.65 on the April spread if the short strike is exercised, a much better deal than exercising the long call and buying RMBS at $17.50!. However, the price of the long 17.50 strike has increased, also, and the trader sells it for $0.35, which adds to the trade's profitability. The trader could have waited until expiration, in case the stock went back down. But the stock could also keep going up. Once the stock reaches a certain level, the trader gets dealt a loss no matter what. You snooze, you lose.

The advantages of the Bearfoot Call - in a sideways or down-trending market - are pretty clear. We hope you give them a try. CallWriter often picks "Bearfoot Call" plays for our paid members.

Good luck and good trading!