Naked call is an option contract in which the option writer gives the option holder a right to purchase the underlying asset at the specified exercise price without the option writer already owning a compensating position in the underlying asset.
Naked call is much riskier than the covered call because there is a possibility of unlimited loss. Maximum payoff on a naked call is equal to the option premium and maximum loss is unlimited as illustrated in the example.
Example 1: Jaana Hyvönen sold 100 call options on Morgan Stanley (NYE: MS). They carry an exercise price of $24 and she received $3 as premium per option. She does not own any share in Morgan Stanley stock. Discuss her payoff if MS stock price (a) stays below $24, (b) climbs only up to $27 or (c) climbs above $27.
As long as MS stock price stays below $24, Jaana is fine because the option holder will not exercise the option. However, as soon as the price rises above $24, say to $27, the option is worth exercising. As the option holder exercises the options, she will have to purchase 100 MS shares at $27 per share in the market and sell them to the option holder under the option contract at $24. She will lose $3 per option. But since she earned $3 as premium at the inception of the option, she will breakeven overall.
She gets into real trouble when the price of MS stock rises above $27, say to $30. She will have to purchase the stock in the market for $30, sell it to the option holder at $24, and bear a loss of $6 on the option. In total she will suffer a loss of $300 [= 100 × $6 minus the option premium of $300]. Now, theoretically MS price can climb up to $100, even $10,000 or even infinity, because after all there is no upper limit. Higher the price of the underlying asset relative to the exercise price, higher differential loss she will have to bear. Jaana faces a potentially unlimited loss under a naked call option strategy.
Example 2: Naked Call vs Covered Call
Now assume as soon as Jaana sold 100 call options with exercise price of $24 for $3 per option, she purchased 100 shares in Morgan Stanley for $26. She covered her call with her position in the underlying stock and this makes her immune to any movement in the price of the underlying asset. If at the expiration, the price of MS stock is below $24, great! She will not have to sell the shares to the option holder. She will pocket $300 in option premium. If price of MS stock rises to, say $30, she will be immune to it because she already holds 100 shares needed to satisfy the obligation under the option contract. She will just sell the shares at $24 per share. Since she does not need to buy anything from the market, she is not affected even if MS stock rises to say $10,000 or even infinity. This is how covered call protects the option writer form unlimited losses.