NAKED OPTIONS – PART IV
By Michael Craig
If an investor believes that a stock will increase in value between the current date and the option strike date, he or she may want to buy calls. Buying calls is a transaction where the investor buys calls on the open market, and is therefore inherently in a naked position. Buying a call means that you have purchased the right but not the obligation to buy a specified stock at a specified price. The buyer of calls is usually buying calls from investors selling naked calls or covered calls.
As the stock price that the option call represents goes up in value, the value of the call also goes up. An investor buying calls hopes that the option expires for an amount greater than the original purchase price. However, as the strike date approaches, the time value of the option will continue to depreciate. This type of option often expires worthless, and the investor loses all of the initial money invested. An example will make this concept clearer.
For example, ABC Stock is trading at $50 a share, and the $50 call is selling for $4 a share. The purchase of the call is executed the same as if you were selling a call, except for the fact that you are buying instead of selling. This means that you would buy the call on the open market for $4 a share. If you bought 10 contracts (1000 shares) you would be required to pay $4,000 for the purchase of the calls.
If the stock price increases from $50 a share to $60 a share on the strike date, the call will increase in value to $10 a share. The $10 is derived from the difference between the current market price and the option price. The $10 difference in this example is known as the intrinsic value of the option, meaning that the current price is $10 higher than the option price. In this example the investor will profit $6,000 from a $4,000 investment, for a 150% gain in a relatively short period of time.
Time value of the option may add an additional amount to the price of the call, however, the call will always trade for at least the amount of the intrinsic value. On the strike date the time value of the option essentially expires, since there is no more time left. The call will then be worth the intrinsic value at the end of the option contract. If there is no intrinsic value then the option will expire worthless.
However, if the stock decreases in value, the investor will lose all of the initial money invested. If the stock price of ABC stays at $50 or decreases from there, the option will expire worthless. There is no waiting for a rebound to occur, the option doesn’t exist anymore.
Unlike selling naked puts and calls, purchases of naked can only lose the amount they invested. There is no chance of other increased losses like there is with selling naked options. The investor must still get increased option approval status from their brokers, before buying calls, but the approval level is lower than that of selling naked options.
Future segments will continue to explain naked options in greater detail.
This is a segment of the newsletter where we will attempt to answer questions about investing including covered call strategy and procedures. If have any questions about investing or covered calls and NOT about particular stocks send them to michaelc@winninginvestments.com.
Naked Options 
