Daily Gains Letter

High Risk, High Return: One Simple Way to Profit as Stock Prices Plummet

By for Daily Gains Letter |

High Risk, High ReturnIt’s not uncommon for a company to get in trouble and suffer for many quarters, or even years, before there are some improvements. As a result, when a company’s conditions deteriorate, the stock prices follow in the same direction—they decline.

There are many examples of companies that got into a downward spiral and their stock prices plummeted over time—consider companies like Blackberry (NASDAQ/BBRY), formerly Research in Motion Limited, losing its market share to competitors, and Bank of America Corporation (NYSE/BAC) being heavily involved in mortgages during the housing slump.

One way investors can take advantage of this situation is by shorting the stock—betting that the stock will continue to go down. Unfortunately, to do so, they will have to meet their broker’s initial margin requirement and so on and so forth.

Instead of shorting a stock, investors can make use of an option strategy called the “naked call.” By employing this strategy, investors can also generate income for their portfolio.

Essentially, a naked call is a bearish option strategy in which an investor sells/writes a call option without owning the underlying security. As a result, the investor receives the premium selling price of the option and promises to provide stock if the price reaches a certain strike price. Keep in mind, this option strategy should not be confused with a covered call—they both have very different characteristics, risks, and rewards.

How does a naked call work?

Suppose that stock of ABC Inc. is trading at $20.00, but the investor believes it will continue to decline. Instead of shorting the stock, he writes/sells call options expiring in May for $2.50 per share, with a strike price of $25.50. By doing this, the investor will receive $250.00.

On the expiration date, if the stock stays below $25.50, then the investor will take the $250.00 and that will be his or her maximum profit. In contrast, if the stock goes higher, the investor will be forced to buy the underlying security and sell it to the call option buyer at a loss.

With all this said, before adding this option strategy to your income-generating arsenal and taking advantage of the downside, investors should know that it is a very risky strategy, to say the very least. Just like shorting, when employing a naked call strategy, investors can run into deep trouble—their losses can be significant.

Going back to our example above, if, unexpectedly, shares of ABC Inc. go to $35.00, the investor will be forced to buy shares for $3,500.00 plus commission. Even after getting $250.00, the investor will face a loss of $700.00. This is because, as per the call option they wrote/sold for a strike price of $25.50, the investor will have to meet the conditions.

While this investment strategy shouldn’t be used by investors who are trying to protect their capital or those who are closing in on their retirement, if one does employ a naked call strategy, they should at least have some sort of loss control in place. This can be done by buying back the call option they wrote or even buying the stock as they see stock prices climb, so their losses won’t be as bad.

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