What Is a Naked Writer?
A naked writer is the seller of an options contract who does not own the underlying security (for a call option) or does not short the underlying security (for a put option). In other words, the option writer is unhedged.
The trader of a naked call is at risk of realizing unlimited losses because, theoretically, there is no limit to how high a stock's price can go. Such options are known as naked options or uncovered options.
- A naked writer sells an options contract without owning or shorting the underlying security.
- Naked writers profit by receiving premiums for writing and selling options contracts without hedging against adverse movements of the underlying security’s price.
- A trader who writes a naked call is exposed to potentially unlimited losses because there is no limit to a stock's price.
Understanding a Naked Writer
Naked writers try to profit by receiving premiums for writing and selling options contracts without the need to hedge themselves against adverse movements of the underlying security’s price. Options are contracts where the buyer has the right but not the obligation to buy (call) or sell (put) shares at a particular price and future date.
Naked options are attractive to traders and investors because they have the expected volatility built into the price.
Brokers typically have specific rules regarding naked options trading, and inexperienced traders, or those with limited funds, may not be allowed to place this type of order.
Naked Call Strategy
A trader who writes a naked call, by selling call options on the open market without owning the underlying security exposes themselves to potentially unlimited losses, as there is theoretically no limit to how high a stock's price can rise. This is because they have accepted the obligation to sell the underlying stock at the strike price at or before expiration, no matter how high the share price rises.
Naked call writing is often restricted to experienced traders who have a minimum net account equity of $100,000 or more.
If the options contract is exercised, the naked writer will be forced to buy a number of shares at a potentially undesirable price to meet their contractual obligation. In contrast, in a covered call strategy, the trader owns the underlying security on which the call options are written.
Naked Put Strategy
A trader who writes a naked put does not hold the underlying position, which is a short position in the underlying security to cover the contract in case the option is exercised. Because the naked writer has accepted the obligation to buy the underlying asset at the strike price if the option is exercised at or before its expiration date, they will lose money if the security’s price falls.
While the risk is contained because the underlying asset can only drop to zero dollars, it can still be large. In contrast, in a covered put, the trader will maintain a short position in the underlying security.