Key Takeaways
- A naked option is a derivative contract where the seller doesn’t own the underlying asset.
- Naked calls require that the seller must deliver shares they don’t own if exercised, leading to potentially unlimited losses.
- Naked puts oblige the seller to buy the underlying asset if exercised, with losses capped at the asset’s fall to zero.
- Sellers of naked options may profit from premiums if the market moves favorably, but the volatility makes it risky.
- Inexperienced traders should avoid naked options due to their high risk and lack of protective measures.
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What Is a Naked Option?
A naked option involves selling a derivative contract without owning the underlying asset, exposing the seller to significant financial risks. The writer is required to deliver shares that they do not own if a naked call option is exercised. The writer is required to buy shares at an unfavorable price when a naked put is exercised.
Learn about the potential for high losses and the key differences between naked and covered options. We’ll explain the risks and provide strategies you need to know before trading.
Essential Concepts of Naked Options
A naked option, also known as an uncovered option, is created when the seller of an option contract doesn’t own the underlying security that’s needed to meet the potential obligation that results from selling. This is also known as “writing” or “shorting” an option. The seller has no protection against an adverse shift in price. Naked options are attractive to traders and investors because their expected volatility is built into the price.
The seller of the option gets to keep any out-of-the-money (OTM) premium if the underlying security moves in the direction opposite to what the option buyer anticipated. They also get to keep the premium if it moves in the buyer’s favor but not enough to account for the volatility that’s already built into the price. That has typically translated to the option seller winning around 70% of trades, which can be quite appealing.
Selling an option creates an obligation at expiration for the seller to provide the option buyer with the underlying shares or futures contract for a corresponding long position for a call option or the cash necessary for a corresponding short position for a put option. The ultimate effect for a seller who sold a put option would be to create a long stock position in the option seller’s account, a position purchased with cash from the option seller’s account.
The seller must acquire it at expiration based on current market prices if they have no ownership of the underlying asset or the corresponding cash necessary for the execution of a put option.
Important
These positions are highly vulnerable to loss and are called uncovered or naked due to lack of price volatility protection.
Understanding Naked Call Options
A trader writing a naked call option must sell the underlying stock at the strike price by expiration, no matter how high the share price rises. If the option is exercised and the trader doesn’t own the stock, they must buy and sell it to the option buyer to meet the obligation. The ultimate effect is that this creates a short-sell position in the option seller’s account on the Monday after expiration.
Imagine a trader who believes that a stock is unlikely to rise in value over the next three months but they’re not very confident that a potential decline would be very large. Assume that the stock is priced at $100 and a $105 strike call with an expiration date 90 days in the future. It’s selling for $4.75 per share.
They decide to open a naked call by “selling to open” those calls and collecting the premium. The trader decides not to purchase the stock in this case because they believe the option is likely to expire worthless and the trader will keep the entire premium.
There are two possible outcomes for a naked call trade:
- The stock rallies before expiration: The trader has an option that will be exercised in this scenario. The option will be exercised at $105 per share because that exceeds the breakeven point for the option buyer if we assume that the stock rose to $130 on good earnings news. The trader must acquire the stock at the current market price and then sell it (or short the stock) at $105 per share to cover their obligation. These circumstances result in a $20.25 per share loss ($105 + $4.75 – $130). There’s no upper limit for how high the stock and the option seller’s obligations can rise.
- The stock remains flat or lower than $105 per share at expiration: It won’t be exercised if the stock is at or below the strike price at expiration. The option seller gets to keep the premium of $4.75 per share that was originally collected.
Understanding Naked Put Options
A naked call seller faces unlimited risk because there’s no cap on how high a stock can rise. The seller’s risk is contained with naked puts because a stock or other underlying asset can only drop to zero dollars.
A naked put option seller has accepted the obligation to buy the underlying asset at the strike price if the option is exercised at or before its expiration date. The risk is contained but it can still be quite large so brokers typically have specific rules in place regarding naked option trading. Inexperienced traders may not be permitted to place this type of order.
A seller who sold a put option is essentially liable to have a long stock position if the option buyer exercises.
What Is an Out-of-the-Money Option?
An out-of-the-money (OTM) option is the result of an asset’s current market price being less attractive than the strike price. An option that expires out-of-the-money will cost the buyer their premium paid to enter the trade.
What Are the Risks of Selling Naked Options?
The trader is selling without the security of holding some ownership interest in the underlying instrument. It’s generally not a recommended move for a trader who’s new to the game. Losses can be significant.
What Is Implied Volatility?
Volatility is the up-and-down movement of a stock’s price over a prescribed period. It can be historical and based on past fluctuations or it can be implied and effectively forecasted. It’s not firm but rather an estimate that traders can and should use to gauge their best and most advantageous moves, particularly if they’re dealing in naked options.
The Bottom Line
A naked, or uncovered, option is an option where the seller does not own the underlying security. If exercised, the seller may be required to buy the asset at a high price to meet their obligations. Selling naked calls creates a short position for the option seller, while naked puts create a long position.
While naked options can offer an easy profit by collecting the premiums, they can also lead to high losses. Because of the risk and volatility involved, naked options trades should be avoided by all but the most experienced traders.
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