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Uncovered calls is a situation in which the writer of the call has established a reasonable margin with a broker to ensure that the stocks associated with the call can be purchased is the call is assigned. The uncovered call is often referred to as a naked call, partially due to the way this assurance is created. An uncovered call is not backed with cash assets, which would be the case with a covered call. Instead, it is backed with the margin extended by the broker to the investor.
The structure of an uncovered call is essentially a short call option position that is assured by the working arrangement with the broker, and the broker’s estimation of how much of a margin the investor can reasonably afford to carry. When the short put call option positions function according to expectations, the investor stands to realize a substantial amount of return from the call. However, an uncovered call also carries an almost unlimited degree of risk.
Just about the only mitigating factor that does place a limit on the potential for loss with an uncovered call is the amount of margin the broker is willing to extend. However, it is important to understand that a margin is not the same as a credit line. There is rarely any type of agreement in place that will allow the investor to pay off any amount of indebtedness over time. However, it is true that the amount of debt that can result from a bad uncovered call will be less if the margin extended by the broker is smaller. However, it is important to realize that the total indebtedness can still be substantial.
Some investors that choose to engage in an uncovered call from time to time will maintain control of cash assets that can quickly be called upon in the event the call does not work out. These cash assets are usually not associated with the brokerage account and may include funds in bank accounts or other investments that can quickly be liquidated and the proceeds used to settle the debt accrued on the margin.
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