The in-the-money naked call strategy involves writing deep-in-the-money call options without owning the underlying stock. It is an alternative to shorting the stock employed when one is bearish to very bearish on the underlying.
Sell 1 ITM Call
Limited Profit Potential
The main objective of writing deep-in-the-money naked calls is to collect the premiums when the call options drop in value or expire worthless as the underlying stock price declines. Profit is limited to the premium collected for writing the call options.
Premium Received - Commissions Paid
Profit achieved when: Price of Underlying <= Strike Price of Short Call
Unlimited Loss Potential
If the stock price goes up dramatically at expiration, the call writer will be required to satisfy the options requirements to sell the obligated stock to the options holder at the lower strike price by buying the stock from the open market at higher market price. Since there is no limit to how high the stock price can be at expiration, potential losses for writing in-the-money naked calls is therefore theoretically unlimited.
Unlimited
Loss occurs when: Price of Underlying > Strike Price of Short Call + Net Premium Received
Loss = Price of Underlying - Strike Price of Short Call - Max Profit + Commissions Paid
Breakeven point
Strike Price of Short Call + Premium Received
Example
The stock XYZ is currently trading at $48. An options trader decides to writes a JUL 40 in-the-money call for $10. So he receives $1000 for writing the call option.
On expiration date, the stock had rallied to $68. Since the striking price of $40 for the call option is lower than the current trading price, the call is assigned and the writer buys the shares for $6800 and sell it to the options holder at $4000, resulting in a loss of $2800. However, since he received $1000 earlier on, his net loss comes to $1800.
If the stock price drops moderately to $45, the cal writer can realise a profit from the loss in premium value of the call option sold. Since the striking price of $40 for the call option is lower than the current trading price, the call is assigned and the writer buys the shares for $4500 and sell it to the options holder at $4000, resulting in a loss of $500. However, as he had received $1000 for the sale of the call earlier, his profit for the trade is $500.
However, what happens should the stock price had gone down 20 points to $28 instead? Let's take a look.
At $28, the call expires worthless and the writer of the naked call keeps the full $1000 in premiums received as profit.
From the profit graph shown earlier, we can see that the breakeven is at $50 (Call Strike + Premium). So long as the stock price remains at $50 or below, the naked call writer will not suffer any loss.
Commissions
These examples exclude commissions and fees. Include all transaction costs when evaluating the profit or loss of a position.