The maximum loss for a customer who WRITES an uncovered call is:
- A.The premium receivedThe premium received is the short call writer's maximum GAIN, not the maximum loss. It is collected up front, which is what makes it easy to confuse with the risk side of the trade.
- B.The strike minus premiumStrike minus premium is the maximum loss on a short PUT, where the stock can only fall to zero. A call writer loses as the stock rises, and there is no upper limit on how far it can rise.
- C.UnlimitedCorrect - uncovered calls have unlimited risk.
- D.ZeroZero loss is the best case, not the maximum: it happens only if the stock stays at or below the strike and the call expires worthless. The question asks for the worst case, which is unlimited.
Why: An uncovered call writer faces unlimited loss because the stock can rise without limit.
Assume the requirement for writing an UNCOVERED equity call is the premium received plus 20 percent of the underlying stock's market value, reduced by any amount the option is out of the money, subject to an alternative minimum of the premium plus 10 percent of the stock's market value - whichever result is greater. Gideon Marsh writes 1 uncovered XYZ 60 call for a premium of 2 while XYZ trades at 55. What is the requirement?
- A.750 dollarsWrong. That is the alternative MINIMUM (200 + 550). The requirement is the greater of the two results, and the primary formula produces 800.
- B.1,100 dollarsWrong. This is 20 percent of market value alone - it neither adds the premium nor subtracts the out-of-the-money amount.
- C.800 dollarsCorrect. 200 + 1,100 - 500 = 800 under the primary formula, which exceeds the 750 alternative minimum.
- D.1,300 dollarsWrong. This omits the out-of-the-money deduction of 500 dollars. The call is 5 points out of the money with XYZ at 55.
Why: Work both formulas and take the larger. PRIMARY: the premium is 2 times 100, or 200 dollars. Twenty percent of market value is 0.20 times 55 times 100, or 1,100 dollars. The call is out of the money by 5 points (60 strike minus 55 market), which is 500 dollars, and that amount is subtracted. So 200 plus 1,100 minus 500 equals 800 dollars. ALTERNATIVE MINIMUM: 200 plus 10 percent of market value (0.10 times 55 times 100, or 550) equals 750 dollars. The greater of 800 and 750 is 800 dollars.