What Is a Naked Writer?
A naked writer is the seller of an options contract who does not also maintain an offsetting position in the underlying security. In other words, a naked call writer does not have an existing long position, and a naked put writer an existing short position in the underlying security, leaving the option writer unhedged in either case. Such options are also known as uncovered options.
The writer 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. A naked put writer, on the other hand, risks potential losses that can be incurred if the price of the underlying security drops to zero.
- A naked writer sells an options contract without maintaining an offsetting position in the underlying security.
- Naked writers profit by receiving premiums for selling options contracts without hedging against adverse movements of the underlying security’s price.
- A trader who writes a naked option is exposed to a great deal of risk if the market moves against the position.
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.
A trader who writes a naked call can earn a maximum gain equal to the premium that the option writer receives upfront, which is usually credited to their account. So, the goal for the writer is to have the option expire worthless. The breakeven point for the writer is calculated by adding the premium received and the strike price for the naked call.
The maximum loss is theoretically unlimited because there is no cap on how high the price of the underlying security can rise. However, in more practical terms, the seller of the options will likely buy them back well before the price of the underlying rises too far above the strike price, based on their risk tolerance and stop-loss settings.
Naked call writing is often restricted to experienced traders with margin accounts who meet 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.
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.
The most a naked put writer can receive is the premium received from selling the option if the option expires out-of-the-money. A naked put strategy is inherently risky because of the limited upside profit potential and, theoretically, a significant downside loss potential.
The risk lays in that the maximum profit is only achievable if the underlying price closes merely at or above the strike price at expiration. Further increases in the cost of the underlying security will not result in any additional profit. The maximum loss is theoretically significant because the price of the underlying security can fall to zero. The higher the strike price, the higher the loss potential.
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.