My brokerage firm won't allow naked option positions. What does this mean?

By Casey Murphy AAA
A:

A naked position refers to a situation in which a trader sells an option contract without holding a position in the underlying security as protection from an adverse shift in price. Naked positions are regarded as very risky because some positions can, in theory, lead to an unlimited amount of loss. This is why many brokers do not allow inexperienced traders to place this type of order.

For example, if the writer of a call option does not own the underlying security, he will be exposed to extreme risk because if the price of the underlying heads dramatically higher, he will be obligated to sell the underlying to the purchaser at the predetermined strike price. (To learn more, see Naked Call Writing.)

Let's assume that the current price of XYZ Company is $11 and an option trader sells 10 call options with a strike price of $15 for $50 per contract. The price of the option contract is quoted in terms of each share that a contract represents (most commonly, a contract will represent 100 shares). In nearly all publications, you will see a quote such as $0.50, which means that each contract is selling for $50 ($0.50 x 100). In our example, the option writer will collect $500 (($0.50 x 100) x 10), and he is entitled to keep this premium if the price closes below the $15 strike price upon expiration. However, if XYZ Company releases news about its new products and the price soars to $40 and our option writer has a naked position (i.e. he does not hold the shares), he will be required to buy the shares on the market at $40 and sell them to the purchaser of the option at $15. Thus, the option writer would lose the amount equal to the difference between the market price and the strike price, multiplied by 1,000 (which is the number of shares in 10 option contracts), minus the amount received from the sale of the options (($40 - $15) x 1,000) - 500 = $24,500).

The chance that you will incur a large loss like this one is the reason why many brokers do not allow individual traders to place this type of trade, and it is why this type of trade should only be attempted by experienced traders. Theoretically, a company's shares could increase in value without limit, so the option writer would be exposed to unlimited loss potential.

To learn more, see To Limit Or Go Naked, That Is The Question.

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