What is a Naked Option?
A naked option, also known as an "uncovered" option, is created when the seller of an option contract does not own the underlying security needed to meet the potential obligation that results from selling (also known as "writing" or "shorting") an option. Selling an option creates an the obligation of the seller to provide the option buyer with the underlying shares or futures contract for a corresponding long position (for a call option) or the cash necessary for a corresponding short position (for a put option) at expiration. If the seller has no ownership of the underlying asset or the corresponding cash necessary for execution of a put option, then the seller will need to acquire it at expiration based on current market prices. With no protection from the price volatility, such positions are considered highly vulnerable to loss and thus referred to as uncovered, or more colloquially, as naked.
- Naked options refer to an option sold without any previously set-aside shares or cash to fulfill the option obligation at expiration.
- Naked options run the risk of large loss from rapid price change before expiration.
- Naked call options that are exercised create a short position in the seller's account.
- Naked put options that are exercised create a long position in the seller's account, purchased with available cash.
How a Naked Option Works
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 options are attractive to traders and investors because they have the expected volatility built into the price. If the underlying security moves in the opposite direction that the option buyer anticipated, or even if it moves in the buyer's favor but not enough to account for the volatility already built into the price, then the seller of the option gets to keep any out of the money premium. That typically means that option sellers win around 70 percent of trades. A setup that appeals to traders and investors who like to win the majority of their trades.
A trader who writes a naked call option on a stock has accepted the obligation to sell the underlying stock for the strike price at or before expiration, no matter how high the share price rises. If the trader does not own the underlying stock, the seller will have to acquire the stock, then sell the stock to the option buyer to satisfy the obligation if the option is exercised. The ultimate effect is that this creates a short-sell position in the option sellers account on the Monday after expiration. In the case of a seller who sold a put option, the ultimate effect would be to create a long stock position in the option sellers account--a position purchased with cash from the option sellers account.
For example, imagine a trader who believes that a stock is unlikely to rise in value over the next three months, but she is not very confident that a potential decline would be very large. Assume that the stock is priced at $100, and a $105 strike call, with an expiration date 90 days in the future, is selling for $4.75 per share. She decides to open a naked call by "selling to open" those calls and collecting the premium. In this case, she decides not to purchase the stock because she believes the option is likely to expire worthless and she will keep the entire premium.
There are three possible outcomes for a naked call trade:
Outcome #1: The stock rallies prior to expiration.
In this scenario, the trader has an option that will be exercised. If we assume that the stock rose to $130 on good earnings news, then the option will be exercised at $100 per share. This means that the trader must acquire the stock at the current market price, and then sell it (or short the stock) at $100 per share to cover her obligation. These circumstances result in a $30 per share loss ($100 - $130). There is no upper limit for how high the stock (and the option seller's obligations) can rise.
Outcome #2: The stock remains flat near $105 per share at expiration.
If the stock is at or below the strike price at expiration, it won't be exercised, and the option seller gets to keep the premium she originally collected.
Outcome #3: The stock has fallen to any price below $105 at expiration.
In this scenario, assume that the stock dropped to $90 by expiration. There won't be any buyers willing to pay the strike price ($105) for a stock they can buy on the open market for $90 per share. As in outcome #2, the option has no value and the option seller gets to keep the entire premium.
As you can see in the preceding outcomes, there is no limit to how high a stock can rise, so a naked call seller has theoretically unlimited risk. With naked puts, on the other hand, the seller's risk is contained because a stock, or other underlying asset, can only drop to zero dollars. A naked put option seller has accepted the obligation to buy the underlying asset at the strike price if the option is exercised at or before its expiration date. While the risk is contained, it can still be quite large, so brokers typically have specific rules regarding naked option trading. Inexperienced traders, for example, may not be allowed to place this type of order.