Uncovered Option

DEFINITION of 'Uncovered Option'

A type of options contract that is not backed by an offsetting position that would help mitigate risk. "Trading naked", as it is called, poses significant risks. However, an uncovered options contract can be profitable for the writer if the buyer cannot exercise the option because it is out of the money.

Generally, uncovered options are suitable only for experienced, knowledgeable investors who understand the risks and can afford substantial losses.

Also called a "naked option".

BREAKING DOWN 'Uncovered Option'

If a market participant sells a call option without owning the underlying instrument, the call is uncovered. If the buyer exercises his or her right to purchase to underlying instrument, the person who sold the call option (the writer) will need to buy the underlying instrument at its current market price in order to fulfill the contract.

Because of the inherent risks in trading uncovered options, many brokers restrict account holders from writing uncovered option positions, thereby limiting clients' exposure to unlimited market risk.

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