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

By Moe Zulfiqar for Daily Gains Letter | May 2, 2013

It’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 … Read More