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Writing Uncovered Calls
by Dan Keen

CCW Here’s an easy question: What the opposite of being “covered?” “Uncovered,” right! Another way to say that your body is “not covered” by clothing is to say that you are “naked”. It is probably more dangerous to walk around naked than covered (and more polite, too!). Thus the term “naked” has become attached to the practice of writing “uncovered” calls, where the trader does not own any shares of the underlying stock. It might seem strange that you could sell something you don’t own, but such is life in the world of high finance.

In the stock market, it is possible to sell a stock you do not own. You probably have heard the term “selling short.” Brokers may allow you to sell shares of certain stocks you don’t own, by loaning you those shares.

The reason a trader would want to “sell short” is because he or she believes the stock will drop in price. When it dips, the trader buys the stock at the lower price and then gives the borrowed shares back to the broker. The trader pockets the difference in price between the money received from selling the shares and the cost paid to buy them.

The options market has a similar concept in which a trader can sell an option on a stock without owning any shares of the underlying stock. This practice is referred to as “writing uncovered calls,’ or “writing naked calls.” Although still considered a fairly conservative strategy, there is risk… unlimited risk! Think about how selling someone the right to buy 100 shares of a stock from you could get you in hot water if you are called out, especially if you don’t have the cash to back it up! There is no limit to how high a stock can climb, and you would be obligated to buy it, not matter what the cost. That’s why brokers require a lot of equity in an account before allowing such trades. One deal gone bad could wipe out all of your trading capital.

So, why would anyone want to write an uncovered call? One reason is because if the play is successful, your percent return is infinite! Percent return on an investment is calculated by dividing the profit by the cost. What is the cost? Other than a commission fee being taken out of the premium received for selling the call, there is NO COST! No money is invested. Since we cannot divide by zero, our income is all profit, our percent return is infinite.

Another plus to uncovered call writing is that since cash is not tied up in an underlying stock, it can be left in the brokerage account collecting interest or use to purchase another stock for the purpose of writing another covered call.

What is our play here? When we write a covered call, our opinion of the underlying stock is neutral to slightly bullish. We do not want the stock to drop in price, since we own it. However, we might write an uncovered call on a stock we are neutral to slightly bearish on.

Suppose Amazon (AMZN) has been trading in a range between $9 and $9.75 for quite some time. You don’t anticipate any news on the company in the near future that would move the stock greatly in either direction. Suppose also that at this time, the entire retail sector is out of favor with “the crowd”. One play might be to write a covered call with a strike price of $10 one month out. But this would require you to tie up over $900, and would put that money at risk (the stock could drop). You would rather have the money working on other deals. Writing an uncovered call might be a better idea. Picking a $10 strike price one month out, your bet is that the stock will remain under $10 from now until the expiration date. Should that scenario play out, you paid nothing for the stock and get to keep the premium you received!

Because of the ever-present risk that you could be called out and required to purchase the stock to satisfy the assigned option, brokers usually place high requirements on a trader’s account before the will allow uncovered call writing, often requiring that between $10,000 and $50,000 in cash and securities be present in your account. For that reason alone, writing uncovered calls is a strategy many small traders will not be able to do. Hopefully, with time and experience, you can build up your knowledge and enough equity in your trading account to try your hand at this high yielding strategy.
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