Page 303

Covered/Uncovered Call Options

We left the last section with your predicament of coming up with 200 Ford shares, as per your two contracts, they are being assigned. There is no reneging on your option contracts here. You have to meet your obligation. Suppose at the expiration of FAJ, Ford is trading at $60. This means that you have to buy 200 shares of Ford at the cost of $12,000 and then sell them for the strike price of $50 for the total of $10,000. This translates to an apparent loss of $2,000. But since you had collected $400 on writing those 2 FAJ contracts originally, your total loss would be $1,600. Certainly not a day of celebration for you. And you thought you had made money writing call options.

In this situation you had written what is known as uncovered or naked call options. In other words, you sold call options without actually having the underlying stock. As you can imagine, this is a mighty big risk with technically unlimited loss potential. Suppose Ford had gone to $200 at FAJ expiration. Your loss would have been $29,600 on those two contracts! Now chances are that Ford stock would never make that kind of a leap in 20 days but your broker will not take any chances either. In order for you to write naked calls, your broker must qualify you first. And that means that first you have to demonstrate that you understand the risks of writing naked calls (through experience or other means) and second (and more importantly) you must have the means to cover losses should things go sour. In other words, your broker would require you to maintain a certain level of equity (cash or stocks) in your account depending on the number of naked calls you are about to write. This way your broker can go ahead and pay off your obligation if you decide to skip town. At this point you may ask, why write January 50 calls. Let’s write January 65 calls on Ford instead. Chances are that Ford will never make it to $65, those options would expire worthless, and you would keep the proceeds. My response: this is …