An uncovered call, also known as a naked call, is a short call option position secured by a margin extended by the broker. It carries a high degree of risk, but investors can limit potential losses by retaining control of cash assets.
Uncovered calls are a situation where the caller has established a reasonable margin with a broker to ensure that the shares associated with the call can be bought if the call is assigned. The uncovered call is often referred to as the naked call, partly because of the way this guarantee is created. An uncovered call is not backed by cash assets, as would be the case with a covered call. Instead, it is backed with the margin extended by the broker to the investor.
The structure of an uncovered call is essentially a short call option position that is secured by the working agreement with the broker and the broker’s estimate of how much margin the investor can reasonably afford. When short-term call option positions perform according to expectations, the investor can earn a substantial amount of return on the call. However, an uncovered call also carries an almost unlimited degree of risk.
The only mitigating factor that limits the potential for loss with an uncovered call is the amount of margin the broker is willing to extend. However, it is important to understand that a margin is not the same as a line of credit. There is rarely any type of agreement that allows the investor to pay off any amount of debt over time. However, it is true that the amount of debt that can result from a misdiscovered call will be less if the spread spread by the broker is less. However, it is important to realize that the total debt can still be substantial.
Some investors who choose to participate in an uncovered call from time to time will retain control of cash assets that can be quickly called upon in the event the call does not work. These cash assets are generally not associated with the brokerage account and may include funds in bank accounts or other investments that can be liquidated quickly and proceeds used to pay off accumulated debt on margin.
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