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Last week we bought (that is, went long on) an ITM call. This week we’ll watch what happens when we go short on an OTM call. A trader who goes short on a call can also be referred to as the writer of the option contract.
When I first began trading options, it took a while to get my head around the idea that I could write a contract to sell something I didn’t have. But there are everyday examples of people doing this outside of the option market. Some months ago, I contracted to have a house built. The builder signed a contract for its sale to me even though construction had not begun. He had obligated himself to sell a house at a certain price, and now he’s legally bound to deliver it to me, despite increased costs in material and labor. A trader who goes short on a call faces a risk similar to the risk my builder has taken on.
The buyer of an option can exercise the call at any time. As a trader who wrote the short call, you could be assigned to cough up the contracted number shares at the strike price and do so no matter how much the underlying price soars. That means that your max risk as the writer of a call is unlimited. That’s why I would never, never advise anyone to trade naked short calls. We’ll discuss more about naked shorts as time goes on.
Meanwhile, let me digress into a story. You may recall the earlier posting about the volatility of Gamestop (GME). Gamestop was a struggling company, and some professional investors thought it was a safe bet that its stock would tank. So many thought so that in aggregation they shorted more shares of GME than actually existed. When GME’s stock soared on the wings of retail traders associated with the subreddit r/WallStreetBets, it was the beginning of the end for Melvin Capital, a major investment fund that had managed twelve and half billion dollars. Read the gory details on Wikipedia. The moral of the story: before you short, make sure you have access to the shares you might need to cover your obligation.
It’s Monday morning, and I’ve made two trades with September 2, 2022, expirations. Both trades are on the SPDR S&P 500 ETF Trust (SPY). This underlying is an Exchange Traded Fund (ETF) that mirrors the S&P 500. It’s a high volume, high liquidity fund with tight bid ask spreads. These are not imaginary trades, but they are paper trades. It’s only monopoly money, but the numbers all reflect real-world conditions.
The first trade is a naked OTM call with a strike of $426. The order filled at $2.12. The analyze tab on TOS provides a profile of this trade. The x-axis is the price of the underlying and the y-axis is the profit/loss on the trade. The blue line corresponds to the value of the trade at expiration and the purple line displays the value of the trade at any intermediate day prior to expiration in a purple line. The gray shaded area of the charts marks an area within 1 standard deviation of the price of the underlying given its volatility. I have found the analyze tab to be extremely useful, and I highly recommend you learn more about its use. You should be able to find a lot about it online.

This naked short call is neutral to bearish. As long as the price of SPY stays below our strike of 426, we stand to profit $212.00–the credit we received when we opened the trade. But if the price for SPY rises above the strike, we will find ourselves in dangerous territory. This trade has an undefined risk. It could theoretically cause us to lose more money in our account. That’s why our broker has reserved $7383 of our capital to cover this trade. The broker will increase that amount should the trade move against us. If your account doesn’t have the funds to cover the amount that needs to be reserved, you will receive a margin call.
Let’s look at the second trade, which consists of two option contracts rather than one. In this trade we will also sell the 426 call, but we will define our risk by buying a 427 call. Here’s the profile:

The short leg of this spread brought in a credit of $2.07, the long leg cost us $1.80. So we received a net credit of $0.27 per share. Our max profit is $27 for the trade. Our max loss is $73. Since this trade involves two contracts, our transaction fee will total $1.30. Because this trade has a defined risk, the broker has reserved only $100 of our capital.
Let’s judge the capital efficiency of our two trades by comparing how much profit can be received for each dollar the broker will reserve to cover the trade.
Naked Call | Vertical Spread | |
Req’d Funds | 7383 | 100 |
Max Profit | 212 | 27 |
Profit per Dollar | $0.0287 | $.27 |
Sometimes you’ll hear the cost of an option referred to as a premium, the same as the payments on an insurance policy. In the case of the long leg on our vertical spread the comparison to insurance is totally applicable, because it dramatically reduces our risk in addition to freeing up capital to employ in other investments. Before ending this post, I should point out that some trading accounts won’t allow a naked short option.
Key take-away: don’t walk naked in the marketplace.
Morning has dawned on August 23. Overnight futures were flat and in the first half hour of trading the S&P has moved little. Yesterday, after we opened our two bearish biased trades, the S&P had one of its biggest declines of the season, losing over 2%. I’ll track these trades through to expiration, updating this post every morning around 10 o’clock and at market close. The results will appear at the end of the post, and I’ll insert a running commentary starting at this point.
The characteristic of the options that we are trying to profit from in this trade is time decay, also known as theta. The biggest risk factor is the possibility that the SPY will soar above the 426 strike we’ve sold. Because we’re doing an academic exercise, I’ve forgone the trade selection and management practices that I’d normally employ. Most important among these would be to have established at the time of the trade an exit point for taking profit and a second exit point for limiting loss should the trade turn against us. One technique we could use for establishing a profit target is to pick a percentage of our max gain and close the trade when that is achieved. A technique for stopping further loss is to close the trade when the underlying price climbs above our short strike.
8-23-22 1600. The market hardly moved today, which was good news for our trade. The gains recorded below for today are almost entirely due to time decay; that is, theta. Notice that the gain for the naked call approximated 10 times the gain for the vertical spread, even though, the buying power required for the vertical spread is only $100 vs. the $6952, which is the new reserve for the naked call. For the capital required used in the naked spread we could have bought 69 spreads. You can calculate what our profit would be on the spread by multiplying our spread profit by 69. As the equity we have in the naked call changes, we can expect to see variation in the buying power, but the capital efficiency of the spread will usually be many times greater than that of the naked call.
8-24-22 1000. Overnight futures were flat, and have continued flat so far this morning. Our gains in both trades continue to be a product of time decay. Can you think of another case when money can be made by the decrease in value of an asset over time? Where the business model itself is to make money on an asset that depreciates? Sure. That’s how car dealerships make a considerable portion of their profits. Sell a new car for $30,000. Buy it back on a trade-in for $20,000 after depreciation has had its way with it. One could argue that the recycling industry similarly earns profit. The value of an aluminum can exceeds its material cost when it seals a beverage. When empty, the can’s value to many people becomes negative, and they are happy to throw it away or give it away. But the aluminum in the can continues to have intrinsic value, which, in large quantities, can become significant.
8-24-22 1600. The changes in value for our trades reflect a movement in the underlying price as well as the shortening of time till expiration. Implied Volatility decreased slightly today, but the main factor that our trades lost value was the increasing price of the underlying. At the end of the day, the price of a share of SPY will control the lion’s share of our profit pie.
8-25-22 1000. SPY reflects the upward movement of the S&P this morning. Again we’re seeing what happens when the underlying price moves against our trade. Although our equity in these trades has decreased, if the price of SPY remains less than $426, we will achieve the maximum profit at expiration. Although, we will let these trades run through to expiration as an academic exercise, we should be interested in what our chances of success are. We can gain insight into our probabilities for success by using probability anlysis tool available on TOS’s Analyze tab.

The image above shows a cone that encloses an area that projects price levels into the future using a probability range of 68.27%. Recall from high school math that 68% equates to about one standard deviation on a normal distribution. The lower orange dotted horizontal line marks SPY’s current price and the upper line marks our strike price. The table below the graph displays percentages associated with the price levels marked by the orange lines and option expiration dates. From this table we see that there is a probability of 26.54% that our option will expire above the strike price. We can conclude, then that at this moment we have a 73.46% probability of achieving maximum gain on our trade. However, the chart doesn’t tell us anything about how SPY’s price might vary between now and expiration. For that we need to find out what the chances are that SPY will touch above our strike price. The analyze tab can calculate that too for us.

Using the probability of touching image reveals that there is a 49.09% chance that sometime in the next 8 days that SPY may reach our strike price. We’ll see what happens.
8-25-2022 1600. The SPY soared this afternoon, and our trades continued to suffer.
8-26-2022 1000. SPY gave back a little bit of yesterday’s gains. It’s still trading at a level that promises a good gain on both of our trades. Next week as time decay wraps up, we should begin to see profitability in both trades, provided SPY continues to trade at or below its current level. As I’m composing this, the Fed Chair has just made an announcement that the market is interpreting as hawkish, and SPY is falling in response. If this decline continues throughout the day, we can expect to see gains at market close.
8-26-2022 1600. The S&P suffered its biggest one-day drop since mid-June, and the value of our trades soared. If this were a real trade, I would close both trades and take the profit, but we will hold out for the last pennies of profit just to see what happens. Ordinarily, if a trade returns 80% of its max profit, I’ll close. Other traders have different criteria that they use. Recall the max risk we began with for these trades. That risk is now elevated by our unrealized gains. For the spread, that means we are now risking $100 to make another $2. It doesn’t seem worth it. The market lost 3.3% today. That was enough to scare a lot of people into selling. Over the weekend some cooling of the passions that spurred this selling might embolden some to pick up bargains when the market reopens on Monday, especially if after hours trading this weekend shows upward movement.
8-29-2022 1000. SPY seems to have stalled just above 400 and may be reversing. The value of our trades continues to climb. There’s very little extra profit that we could wring from them. Holding onto them at this point offers almost nothing but continued risk. But we’ll take these trades all the way.
8-29-20220 1600. Little movement in the market. No change in the value of our trades, because they have very little growth potential.
8-30-2022 1000. Our trades remain static, will continue on so unless SPY pops higher.
Change of plan. I know I said we’d stay with these trades to the bitter end, but given that we’ve wrung out almost all of the profit potential, I just don’t see the purpose of locking up capital for very little potential gain.
Date | Time | Mark | Naked Call P/L | Vertical Spread P/L | ||
8-23-22 | 1000 | 413.88 | 65 | 6 | ||
8-23-22 | 1600 | 412.51 | 98 | 10 | ||
8-24-22 | 1000 | 412.39 | 118 | 12 | ||
8-24-22 | 1600 | 413.64 | 114 | 10 | ||
8-25-22 | 1000 | 416.46 | 66 | 4 | ||
8-25-22 | 1600 | 419.43 | 8 | -4 | ||
8-26-22 | 1000 | 418.55 | 24 | -1 | ||
8-26-22 | 1600 | 405.14 | 200 | 25 | ||
8-29-22 | 1000 | 402.96 | 206 | 26 | ||
8–29-22 | 1600 | 402.63 | 206 | 26 | ||
8-30-22 | 1000 | 402.24 | 206 | 26 | ||
8-30-22 | Trade closed due its success |
Below is an analysis of our trades’ successes. In both cases, we see very respectable gains that benefitted greatly from the leverage that options provide. The defined risk and capital efficiency of the vertical spread makes it my favorite. Keep in mind, though, that had the SPY moved decisively in the other direction, both of these sweet trades would have quickly soured. Our next post will more extensively explore factors that contributed to their success.
Naked Short | Bear Call Vertical | ||
Buying Power Used | 7383 | 100 | |
Max Risk | Infinite | 73 | |
Max Gain | 212 | 26 | |
Realized Gain | 206 | 26 | |
Contract Fees | 1.30 | 2.60 | |
Net Gain | 204.70 | 23.40 | |
Capital Efficiency | 2.77% | 23.4% | |
Length of Trade | 8 days | 8 days | |
Approxiate Annualized Return on Capital | 126% | 1067% |