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. Tame Panic Selling with the Exhausted Selling Model

    The exhausted selling model is a pricing strategy used to identify and trade based off of the price floor of a security. ... Read Full Answer >>
  2. Point and Figure Charting Using Count Analysis

    Count analysis is a means of interpreting point and figure charts to measure vertical price movements. Technical analysts ... Read Full Answer >>
  3. What assumptions are made when conducting a t-test?

    The common assumptions made when doing a t-test include those regarding the scale of measurement, random sampling, normality ... Read Full Answer >>
  4. How does a forward contract differ from a call option?

    Forward contracts and call options are different financial instruments that allow two parties to purchase or sell assets ... Read Full Answer >>
  5. How are double exponential moving averages applied in technical analysis?

    Double exponential moving averages (DEMAS) are commonly used in technical analysis like any other moving average indicator ... Read Full Answer >>
  6. How do you know where on the oscillator you should make a purchase or sale?

    Common oscillator readings to consider making a buy or sale are below 20 or above 80, respectively. More aggressive investors ... Read Full Answer >>
Related Articles
  1. Chart Advisor

    ChartAdvisor for September 4 2015

    Weekly technical summary of the major U.S. indexes.
  2. Forex Strategies

    Two Great Currencies To Profit From Oil Volatility

    U.S. dollar crosses with Canadian and Australian dollars offer easy access to crude oil trends due to their tight correlation with energy futures.
  3. Investing

    Redefining the Stop-Loss

    Using Stop-losses for trading doesn’t mean ‘losing money’, but instead think about the money you'll start saving once you learn how they work.
  4. Chart Advisor

    3 Ways to Trade the Rising Volatility

    With volatility increasing in the markets, many are turning to these three volatility-capturing exchange-traded products.
  5. Trading Strategies

    Stock Trading for Free: Now a Reality

    Believe it or not, you can now trade stocks and ETFs for free. Here's a look at providers offering commission-free trading.
  6. Chart Advisor

    Big Double Top Patterns On the Verge of Breaking

    These stocks have created big double top chart patterns, and are on the verge of breaking the patterns to the downside--a bearish signal.
  7. Options & Futures

    Use Options to Hedge Against Iron Ore Downslide

    Using iron ore options is a way to take advantage of a current downslide in iron ore prices, whether for producers or traders.
  8. Chart Advisor

    Gold Struggles to Climb Higher and May Fall Soon

    Traders will be watching the price of gold over the coming weeks. We'll take a look at how a couple major moving averages are suggesting that the next move could be lower.
  9. Technical Indicators

    Use Market Volume Data to Determine a Bottom

    Market bottoms often carve out classic volume patterns that let observant traders make fast and accurate calls.
  10. Home & Auto

    Understanding Rent-to-Own Contracts

    They can work for you or against you. Here's how to negotiate a fair one.
RELATED TERMS
  1. Implied Volatility - IV

    The estimated volatility of a security's price.
  2. Plain Vanilla

    The most basic or standard version of a financial instrument, ...
  3. Normal Profit

    An economic condition occurring when the difference between a ...
  4. Theta

    A measure of the rate of decline in the value of an option due ...
  5. Derivative

    A security with a price that is dependent upon or derived from ...
  6. Security

    A financial instrument that represents an ownership position ...

You May Also Like

Trading Center
×

You are using adblocking software

Want access to all of Investopedia? Add us to your “whitelist”
so you'll never miss a feature!