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.

RELATED FAQS
  1. Are there any risks involved in trading put options through a traditional broker?

    Explore put option trading and different put option strategies. Learn the difference between traditional, online and direct ... Read Answer >>
  2. How is a short call used in a naked call writing option strategy?

    Learn how a short call is used in a naked call writing strategy, and understand the high degree of risk associated with this ... Read Answer >>
  3. What is the difference between a covered call and a regular call?

    Learn what a call option is, what two strategies call options can be used for, and the difference between a covered call ... Read Answer >>
  4. How can derivatives be used to earn income?

    Learn how option selling strategies can be used to collect premium amounts as income, and understand how selling covered ... Read Answer >>
  5. Are put options more difficult to trade than call options?

    Learn about the difficulty of trading both call and put options. Explore how put options earn profits with underlying assets ... Read Answer >>
Related Articles
  1. Trading

    Naked Options Expose You To Risk

    Find out why these enticing options can spell trouble for your bottom line.
  2. Trading

    Naked Call Writing: A Risky Options Strategy

    Learn about this aggressive trading strategy to generate income as part of a diversified portfolio.
  3. Trading

    The Basics of Options Profitability

    The adage "know thyself"--and thy risk tolerance, thy underlying, and thy markets--applies to options trading if you want it to do it profitably.
  4. Trading

    Options Strategies for Your Portfolio to Make Money Regularly

    Discover the option-writing strategies that can deliver consistent income, including the use of put options instead of limit orders, and maximizing premiums.
  5. Trading

    A Guide Of Option Trading Strategies For Beginners

    Options offer alternative strategies for investors to profit from trading underlying securities, provided the beginner understands the pros and cons.
  6. Trading

    Trading Options on Futures Contracts

    Futures contracts are available for all sorts of financial products, from equity indexes to precious metals. Trading options based on futures means buying call or put options based on the direction ...
  7. Trading

    Collecting Option Premium In The Grain Market

    Believe it or not, there are some great income-generating strategies that are lower in risk.
  8. Investing

    The Truth About Naked Short Selling

    The media demonizes naked short selling, but in most cases it occurs in a collapse, rather than causing it.
  9. Trading

    How to Trade Options on Government Bonds

    A look at trading options on debt instruments, like U.S. Treasury bonds and other government securities.
  10. Trading

    The 4 Advantages of Options

    Flexible and cost efficient, options are more popular than ever. Find out why.
RELATED TERMS
  1. Naked Writer

    An options seller who does not own the underlying security for ...
  2. Covered Writer

    An options seller who owns the underlying security represented ...
  3. Writer

    The seller of an option who collects the premium payment from ...
  4. Uncovered Option

    A type of options contract that is not backed by an offsetting ...
  5. Naked Put

    A put option whose writer does not have a short position in the ...
  6. Naked Shorting

    The illegal practice of short selling shares that have not been ...
Hot Definitions
  1. Down Round

    A round of financing where investors purchase stock from a company at a lower valuation than the valuation placed upon the ...
  2. Keynesian Economics

    An economic theory of total spending in the economy and its effects on output and inflation. Keynesian economics was developed ...
  3. Portfolio Investment

    A holding of an asset in a portfolio. A portfolio investment is made with the expectation of earning a return on it. This ...
  4. Treynor Ratio

    A ratio developed by Jack Treynor that measures returns earned in excess of that which could have been earned on a riskless ...
  5. Buyback

    The repurchase of outstanding shares (repurchase) by a company in order to reduce the number of shares on the market. Companies ...
  6. Tax Refund

    A tax refund is a refund on taxes paid to an individual or household when the actual tax liability is less than the amount ...
Trading Center