All investments in options involve risk, but some options strategies are significantly riskier than others. Writing covered call options is a conservative investment strategy that does not involve any risk of loss, but significantly limits your potential gain. Writing uncovered calls is a wildly speculative strategy that offers only limited gain while risking potentially unlimited loss.
An equity option is a financial product that conveys the right to buy or sell the underlying stock at a set price, called the strike price, for a specific period of time. Call options give the holder the right to buy stock at the strike price, while put options give the holder the right to sell stock at the strike price. You can make money trading options without ever actually exercising your options, but unlike stocks, options have an expiration date. Once that date passes, your options become worthless and cease to exist. When you buy options your entire investment is at risk.
Writing Uncovered Call
The riskiest of all option strategies is selling call options against a stock that you do not own. This transaction is referred to as selling uncovered calls or writing naked calls. The only benefit you can gain from this strategy is the amount of the premium you receive from the sale. If the price of the underlying stock remains below the strike price through the option's expiration date, you make a tidy profit. If the stock rises above the strike price, you run the risk of someone exercising their option. You would then have to purchase the stock at the current market price, and sell it to them at the lower strike price. Your loss might be mitigated somewhat by the amount of the premium you received from the option. The worst case scenario is if the stock takes off like a rocket. Perhaps the demand is so great that you have a hard time buying the stock. You are still obligated to deliver the stock, so you have to pay whatever the market demands. Your risk, at least in theory, is unlimited.
Writing Uncovered Puts
Selling uncovered put options, or writing naked puts, involves slightly less risk than selling uncovered calls. Your potential loss is not unlimited, but it is substantial. This strategy involves offering to purchase the underlying stock at a set price, when you have no desire to own the stock and no resources set aside to purchase the stock should the option be exercised. Like writing a naked call, the only benefit you can gain from this strategy is the amount of the premium you receive. As long as the stock price remains above the strike price, you are safe. But if the stock drops like a rock you may be compelled to buy the stock at the strike price when it is worth considerably less.
A short straddle is an options strategy that involves simultaneously writing a naked call option and writing a naked put option on the same stock with the same strike price and expiration date. You get a premium from both transactions, and as long as the stock trades within a narrow range until the options expire everything is fine. If the market price of the stock drops dramatically, your risk of loss is substantial. If the stock price rises dramatically, your risk is unlimited. This strategy involves substantial to unlimited risk while providing only a limited reward.
Mike Parker is a full-time writer, publisher and independent businessman. His background includes a career as an investments broker with such NYSE member firms as Edward Jones & Company, AG Edwards & Sons and Dean Witter. He helped launch DiscoverCard as one of the company's first merchant sales reps.