"Breakeven Point for Naked Call Write?"

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"Breakeven Point for Naked Call Write?"

"When doing a naked out of the money call write, how low can the stock go before you start losing money or is it better for it to reach its strike price?"
- Asked By Tony Guzman on 7 July 2011

Answered by Mr. OppiE

Hi Tony,

First of all, when you write call options, you want the price of the stock to go down. Writing call options is a bearish options strategy and profits when the price of the underlying stock goes downwards and loses money when the price of the underlying stock goes upwards. As such, I am going to answer your question based on how "HIGH" the stock can go before losing money.

Writing out of the money call options, or OTM Naked Call Write, loses money actually in two ways; Before expiration and During expiration.

Before Expiration
All options positions with some time left to expiration reacts to changes in the price of the underlying stock based on their "Delta" value. Delta is an options greek that governs how much the price of an option could theoretically change with a dollar move in the underlying stock. Writing out of the money call options gives you negative delta which means that the position profits when the price of the underlying stock goes downwards and loses money when the price of the underlying stock goes upwards. At this juncture, before expiration, you can lose money with writing out of the money call options when the price of the underlying stock goes down despite not hitting the strike price of the call options itself. This is because the price of call options appreciate as the price of the underlying stock draws nearer to its strike price. Here's an example.

Example of Naked Call Write Before Expiration Assuming you wrote 1 contract of QQQ's $46 strike price call options when QQQ was trading at $44 for $0.50 with a delta value of 0.30. By writing 1 contract of this $42 out of the money call options, you gain a credit of $0.50 x 100 = $50 and a total delta value of -30. Yes, writing call options gives you negative delta. Assuming QQQ gains $1 to $45 in a single day. Your $46 call options are still out of the money with no risk yet of being exercised but the options would have gained: $1 x 0.30 = $0.30 in value for a total price of $0.80 now. This means that if you would to buy to close the position right now, you would have to do it at the higher price of $0.80, thereby losing $0.30.

During Expiration
However, if you decide to hold your OTM naked call write position all the way to expiration, then you won't be too concerned with how delta is changing the price of your call options in the interim. Ultimately, by expiration, it is whether or not the price of the underlying stock has exceeded the breakeven point of the position that matters. This is why calculating and knowing your breakeven point is so important in options trading. If you are holding the above position all the way to expiration, you would not have bothered with the interim paper loss but would have continued to hold the position to profitability as the stock has not exceeded the breakeven point of the position.

Example of Naked Call Write During Expiration Assuming you wrote 1 contract of QQQ's $46 strike price call options when QQQ was trading at $44 for $0.50 with a delta value of 0.30. By writing 1 contract of this $42 out of the money call options, you gain a credit of $0.50 x 100 = $50 and a total delta value of -30. Yes, writing call options gives you negative delta. Breakeven Point of Naked Call Write = Strike Price + Net Credit = $46 + $0.50 = $46.50 This means that as long as the price of the underlying stock is below $46.30 by expiration, the position remains profitable and you will make the net credit of $50 as profit.

Yes, as long as the price of the stock remains below $46.50 in the above example, that build up of "hot air" extrinsic value from $0.50 to $0.80 would simply disappear due to time decay as the options trading position approaches expiration, finally allowing the call options to expire worthless out of the money and making you that $50 as profit.

In conclusion, while a naked call write position could post paper loses before expiration when the price of the underlying stock rises, it is ultimately the breakeven point that determines whether or not the position is profitable by expiration of the position. As such, it is good to always know the delta exposure and breakeven point of all options strategies that you execute at all times.