Wednesday, May 14, 2008

Dangers of selling naked calls

Many people start selling naked calls in the stock market before they fully analysis the risk that it involves. This is a big mistake.

To understand what a naked call is you should first understand what a call is. When you buy a call what you actually do is buy the right to buy a given stock at a given price on or before a given date. For this you would pay a fee.

When you sell a naked call you are trying to capitalize on that fee they pay. You can actually sell a call even if you do not have that stock to offer. So say you sell the $45 call on a stock that is trading at $41 for $3.

You would make $3 initially. But you are obligated, until the option expires, to buy the stock at whatever price it is trading for and sell it for $45. If the stock does not go above $45 you walk away with $3.That sounds pretty good doesn’t it? As long as this stock does not go up 10% in the near future you can still make money.

What some people fail to realize is that your max loss is infinite. If the stock goes up to $46 you have to buy it at $46 and sell it at $45. You lose $1 here, not bad considering you made $3. But what If the stock goes up to $80 or $90, or higher? That can seriously hurt you, and maybe bankrupt you if you sold enough shares.

Because there is no limit to how high a stock can go you are risking an infinite amount of money to make $3. That is not exactly a great idea.

There is a great way to lessen your loss, however. This is done by turning the naked call trade into a bear call spread. Let us look at the example above. We sold the $45 put for $3. This time we also bought the $50 put for $1.5.

Now we lessened our gain to $1.5, but also lessened our loss. If the stock goes up to $80 it doesn’t matter. We can buy it at $50 and sell it at $45 giving us a $5 loss instead of a $35 loss. Much better.

To find out more information on how to trade the stock market visit

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