Friday, October 12, 2007

Selling Uncovered Calls - Part 2

You will need approval in advance from your brokerage firm before you will be allowed to sell calls. Each firm is required to ensure that you understand the risks involved, that you fully understand the options market, and that you have adequate equity and income to undertake those risks.

You will not be allowed to write an unlimited number of naked calls. The potential losses, both to you and to the brokerage firm, place natural limits on this activity. Everyone who wants to sell calls is required to sign a document acknowledging the risks and stating that they understand those risks. In part, this statement includes the following:

Special Statement for Uncovered Option Writers

There are special risks associated with uncovered option writing which expose the investor to potentially significant loss. Therefore, this type of strategy may not be suitable for all customers approved for options transactions.

1. The potential loss of uncovered call writing is unlimited. The writer of an uncovered call is in an extremely risky position, and may incur large losses if the value of the underlying instrument increases above the exercise price.

2. As with writing uncovered calls, the risk of writing uncovered put options is substantial. The writer of an uncovered put option bears a risk of loss if the value of the underlying instrument declines below the exercise price. Such loss could be substantial if there is a significant decline in the value of the underlying instrument.

3. Uncovered option writing is thus suitable only for the knowledgeable investor who understands the risks, has the financial capacity and willingness to incur potentially substantial losses, and has sufficient liquid assets to meet applicable margin requirements. In this regard, if the value of the underlying instrument moves against an uncovered writer's options position, the investor's broker may request significant additional margin payments. If an investor does not make such margin payments, the broker may liquidate stock or options positions in the investor's account, with little or no prior notice in accordance with the investor's margin agreement.

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