May 19, 2004

Writing Naked Calls with CallWriter
By John Brasher, CallWriter Publisher

Many of our members do not write covered calls or only write them occasionally as part of a multi-faceted trading approach. In fact, a lot of our members use the Real Time Lists™ for naked calls, in particular. This issue of the MNL will explore some of the ins and outs of using CallWriter to find and execute naked call trades.

As you will see, writing naked calls is like stealing money out of the market - if you can consistently pick "lousy" stocks (lousy to buy, that is), or at least stocks that aren't going up before expiration. CallWriter is known around the world as one of the premier covered call websites, but is used extensively by naked call writers, as well. Read on to learn why.

"Naked" and "covered" calls
A covered call is a trade in which the trader owns the stock and sells call options against it. The calls are considered "covered" because the trader owns the stock underlying the calls, and can instantly deliver the stock if called out. The covered call writer's brokerage firm isn't concerned about risk, since the stock is in the writer's account.

But some traders prefer instead (or also) to write naked calls. Calls are naked when the trader does not own the underlying stock. Naked calls are highly risky, because If the calls are exercised, the naked call writer will be forced to go into the market to buy the underlying stock at a price higher than the calls' strike price in order to deliver the stock. The naked call writer thus can be badly hurt.

Risk Profile
Limited return (the premium received), high risk. The naked call involves a net credit, meaning income to the call writer with no investment whatsoever, which is why we refer to it as the closest thing to stealing money that still is legal. When done properly, the naked call write is extremely profitable. But the risk - at least theoretically - is high, as described below. The naked call writer is at risk that he will have to buy the stock to meet a call exercise at a price substantially higher than the strike price.

Example: When XYZ stock is $15, Joe writes the XYZ 15 call naked. But before expiration XYZ moves to $22. When the calls are exercised, Joe will receive the $15 strike price but will have to buy the stock in the market at $22, for a $7 loss per share.

So the risk to the naked call writer is theoretically unlimited, since there is no theoretical limit to the price the underlying stock could reach. In reality, this is not true. Every call has an expiration date, and a stock can only move so far in a given time period. But as the great bull market of the 1990s indicates, stocks can move dramatically.

Example: In May 2004, OSI Pharmaceuticals (OSIP) gapped overnight from $39 to about $80 and then soared to almost $100 before pulling back in the $70's. A trader who wrote any call naked on that stock at the $40 level got slaughtered.

Stock profile
In order to successfully write naked calls, you have to be able to regularly pick stocks that:

• are going down

    or

• are not going up

While beyond the scope of this article, in order to determine likely stock direction, a combination of fundamental and technical analysis is required, and good charting is essential. If you can consistently pick stocks that will decline or hold price, then naked call writing literally is very much like stealing money out of the market. But if you are not good at reading the charts, you should hold off on naked calls until you get more experience. Keep in mind that stocks carrying high premium are potentially volatile - that's why the premium is high. The market considers the underlying stock to be more likely than other stocks to move based on impending events (and the movement will present a profit opportunity) than other stocks at the time, and that is why the options are priced higher.

In other words, good naked call stocks are those that make rotten covered call candidates, the ones you DON'T want to own.

Trading Tip:  It is not wise to write naked calls - or covered calls, for that matter - on event-driven stocks, which are those with major news (for example, FDA ruling on drug application) expected prior to expiration. What is "major" will vary by company, of course. For example, the fate of one drug application might not matter to Amgen's stock price, but might decimate a small company with only a couple of drugs in development; or take it to the moon. So always do your homework, please. Never write a naked 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.

Naked writing on a stock in a pronounced downtrend is usually a good tactic. Writing naked on the expectation that the stock is about to take a hit can also be a good trading tactic, but what if you guess wrong and the stock moves up? The point is that you cannot be guessing. If you are not sure the stock will hold price or decline, pass on it. It also helps if the overall market, or the stock's industry, is falling, since a falling tide tends to pull all boats down.

Brokerage Requirements - the Catch
Big premiums, no cash investment required, you only have to be able to pick lousy stocks... Because they are so magnificently profitable, you knew there had to be a catch to writing naked calls, and there are several. Because the risk is theoretically unlimited, brokerage firms severely limit who can write naked calls and how they are written. First, only investors with an option account approved for Level 4 or 5 options trading (sometimes Level 6) are allowed to write naked calls. Second, most firms require that your options trading account be of a certain minimum size, ranging from $50,000 to $100,000. Third, 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. Some firms do not allow naked call writes at all.

Trading Tip:  But don't despair - there is a way to write almost naked calls, which is known as a bear call spread. You sell the call desired, and then buy a higher-strike call. (EX: Sell the 20 strike call and buy the 25 call, which creates a $5.00 spread). If you gauged the stock's direction wrong, your loss is capped because you have the right to buy the underlying stock at the the higher strike.

Important Writing Tip
Smart naked writers know that the secret to avoiding losses is to cover or close their position if the stock price moves up and reaches the strike price of the call sold. If a trader writes the 25 Call when the stock is $23, the trader should cover or close the position when the stock hits $25. This means either buy back the short calls or buy the stock to cover. By comparison, if the stock is $25 and one writes the 25 call, the trade must be covered or closed if it advances at all, which is silly. The savvy naked writer will always leave some room for the stock to move.

This means that naked writers should always
write a strike that is out of the money (OTM).
Ideally, the stock should be at least 5% less than the strike price, and more is better. If the call strike sold is $25, the stock should be no higher than $23.50, therefore, because there needs to be some room for the stock to move. Stocks frequently move either way (or both ways) before expiration. Writing an OTM call lets the stock move a few percent before expiration without stopping you out of the trade or triggering a cover.

This is why CallWriter offers Deep Out of the Money lists of the highest returning call options. They are designed not only for OTM writing but for naked call writing, as well.

Breakeven Point
Sometimes you'll guess wrong on a stock on which you've written a naked call, and it moves up. And when one moves up, the trick in holding on to your profit (or at the very least avoiding a loss) is to cover the naked calls by purchasing the underlying stock before its price reaches the breakeven point. There is no loss until the stock crosses the breakeven point. Once the stock moves above the breakeven point, you are in negative territory. Here is the simple formula:

Breakeven point = Call's strike price + premium received (less trade costs)

So if you write the XYZ 25 Call for a $1.75 premium, the breakeven point is $26.75 ($25 strike + $1.75 premium). Actually the breakeven is slightly lower, since you had trade costs to write the naked calls, and more trade costs to buy the stock to cover, or buy back the calls.

When to Cover the Naked Call
Once the stock price hits the call's strike price, you are at serious risk of being called out. To protect yourself, the safe practice is to cover naked calls when the stock crosses the strike price by purchasing the stock. So if you write the 25 call when the stock is $23.50, cover by buying the stock after the price moves above $25. Always watch naked call positions closely. You absolutely must set a buy stop order (cover point) with your broker so that the broker covers the call by purchasing the underlying stock at a pre-determined price level. Cover when the stock crosses the strike price and you still should have some good profits left. If you don't cover when the stock hits the strike price, you will sit there watching while the stock movement eats up most or all of your profits.

Examples 1, 2: when the stock is $23.50, you write the 25 Call naked and pocket a $1.75 premium. In this example, your breakeven point is therefore $26.75 ($25 strike + $1.75 premium). The $23.50 is just a reference point, since you are not buying the stock when you open the naked call position. If the stock moves up to $25 before expiration, you are at risk of being called out, and the advance justifiably makes you nervous. Since the stock is moving up (it wasn't supposed to, remember?), you called it wrong. To avoid a loss, cover before or NO LATER than $25. Remember, you have to deliver the stock at $25 if you are called, so the more you pay for the stock above the $25 strike price of the call, the less profit you make, and the greater the loss once the stock moves past your breakeven point.

Below are two illustrations of the above trade, one in which the writer covers at $25.50, and one in which he covers at $26.75, the breakeven point. Cover any higher than $26.75, and the trade yields a loss even before including trading costs:

In example #1, the writer still pocketed a profit, even after trade costs. More importantly, he didn't take a loss. In example #2, the writer broke even because $26.75 was his breakeven point, but actually took a loss after figuring in trade costs. This illustrates the importance of moving to cover a naked call when the stock hits the call's strike price. Suppose the stock moves up to $29 before a lazy call writer decides to cover? Ouch, that would mean a loss of $2.25 per share ($29 cover price - $25 strike price - $1.75 premium).

And you thought we were just a covered call site!

There is a lot more to be learned about writing naked calls, but this article covers the basics. In our upcoming High Performance seminars we will explore in loving detail how you get into and out of these naked call trades, different exit strategies and such.

Good luck and good trading!