You can always attempt to turn a losing trade into a winning trade with theta strategies. Adjusting a trade can turn a loser into a winner, or it could cut your losses in half. Unfortunately, there are times when you should not make adjustments to a losing trade. One case would be with a losing naked call. You should never adjust a naked call.
Why?
Naked calls are one of the riskiest theta strategies. They are the riskiest because they have an unlimited loss potential. That means you could experience infinite losses with naked calls. These plays do not have a defined risk or a max loss.
Understanding the basics is very important when it comes to adjusting naked calls. Once you understand the basics, you will know why you should never adjust a naked call.
The Basics Of A Naked Call
When you sell a call option, you are inverting a call contract. When you are buying a call option, you are purchasing the right to buy 100 shares at a specified price. So when you are selling a call option, you are selling someone else the right to buy 100 shares at a specified price. Since you do not own the shares, you would be forced to take on a short position of 100 shares at that price.
Naked Calls Can Have Unlimited Losses
You should already know this, but I will tell you anyway- short positions can cause your account to go negative! This is because a stock can keep rising with no cap. Whereas when you own shares, the lowest a stock could go is 0.
To exaggerate this point, let me give you an example:
Imagine if you had a short position of 100 shares with a trade price of 100 on stock XYZ. XYZ comes out with a revolutionary product. The stock skyrockets to 550 per share. Let’s see what your loss looks like:
Your $10,000 investment turned into a $45,000 loss! Since you don’t have the funds to cover that loss, you’re going to have to pay back your broker $45,000, plus interest fees!
By going naked on a short call, you are agreeing to short 100 shares of a stock at a specified price. Therefore, you can easily find yourself in a scenario similar to the example above.
If you find yourself in a situation where your naked call goes in-the-money, your best bet may be to close the position for a loss. Let’s take a look at why you should never adjust a losing naked call.
Risks Of Adjusting A Naked Call
You’re probably thinking that it would be wise to adjust a naked call. Most people think that adjusting a naked call is the best decision. The idea is that adjusting a losing trade can potentially limit your loses and can give you more time to be right. It works well with naked puts, so why wouldn’t it work just as well with naked calls?
Adjusting A Naked Call Has The Complete Opposite Effect Compared To Adjusting A Naked Put
Adjusting a losing naked put is really helpful when it comes to minimizing losses. Naked put adjustments help you take capital off the table in a losing trade. The most common adjustment is to roll the losing position to a farther out expiration date and lower the strike.
Rolling a naked put to a farther out expiration and lowering the strike can significantly lower the amount of capital at risk. Changing the expiration date gives your stock more time to recover. Additionally, lowering the strike of the naked put lowers the collateral needed for the trade.
Ready for the bad news? The complete opposite happens when you adjust a losing naked call. Here’s how:
Stocks Have A Natural Tendency To Go Up
Everyone knows that stocks have a natural tendency to go up. Even stocks that are fundamentally screwed up have unforeseen rallies. Plus, there is always the possibility of a fundamentally screwed up company changing its ways and becoming fundamentally sound.
So what happens if something like this happens while you have a naked call? Shouldn’t you just roll the call out to a farther out expiration and to a higher strike?
The answer is absolutely not! Adjusting a naked call exposes you to way more risk. You should never adjust a losing naked call.
Giving Yourself More Time In The Trade Can Increase Your Losses
Since stocks have a natural tendency to go up, don’t you think that buying yourself more time would only hurt you more? You’re giving the stock more time to become bullish.
The longer you’re in the trade, the higher it can go. The higher it goes, the more loses you take on. What are you going to do when it moves high enough to put your account into a negative balance?
Luckily for you, it’s more than likely that by that point your broker would have already issued a margin call and closed your trade.
Now you’re stuck with a huge loss.
Raising Your Strike Is Only A Temporary Fix
Adjusting a losing naked call to a higher strike price is like putting a bandaid over a gunshot wound. Moving your strike from in-the-money to out-of-the-money will only help you if the stock is done rising. If it’s not done rising, you’re opening yourself up to bigger losses.
Moving your strike from in-the-money to out-of-the-money increases your risk because you are moving your strike to a higher strike, thus increasing the amount of collateral you need to put up.
Let’s look at an example:
You have a losing naked call with a strike of 25 on stock XYZ. You decide to adjust your position and raise your strike from 25 to 30. Now if XYZ goes above 30, you’d be required to open a short position at 30 instead of 25. Your broker will require you to put up more money since now you’d have to short 100 shares at a higher trade price (here’s a calculator to test that theory).
Just Close A Losing Naked Call
It’s clear that naked calls aren’t as forgiving as naked puts. Making adjustments is a bad idea. You should never make adjustments to a losing naked call. Your best bet is to close the trade and reevaluate the stock.
You can always choose to initiate a new position if it looks like the stock is turning around and is about to drop. It is not wise to keep adjusting your naked call because adjustments will work against you.
A smart trader knows when they should walk away from a trade. A really smart trader has a risk management strategy when it comes to using risky strategies such as naked calls. My advice to you is- don’t go into a naked call without having an exit plan if things go wrong.