What Is a Naked Option?
A naked option is created when the option writer (seller) does not currently own any, or enough, of the underlying security to meet their potential obligation.
- 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.
Understanding 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. In other words, the seller has no 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 direction opposite to what the option buyer anticipated, or even 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 (OTM) premium. Typically, that has translated to the option seller winning around 70 percent of trades, which can be quite appealing.
Selling an option creates an obligation for 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. 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.
If the seller has no ownership of the underlying asset or the corresponding cash necessary for the 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, naked.
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.
For example, imagine a trader who believes that a stock is unlikely to rise in value over the next three months, but they are 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. They decide to open a naked call by "selling to open" those calls and collecting the premium. In this case, the trader decides not to purchase the stock because they believe the option is likely to expire worthless and the trader will keep the entire premium.
There are two possible outcomes for a naked call trade:
- 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 $105 per share as that exceeds the breakeven point for the option buyer. This means that the trader must acquire the stock at the current market price, and then sell it (or short the stock) at $105 per share to cover their obligation. These circumstances result in a $20.25 per share loss ($105 + $4.75 - $130). There is no upper limit for how high the stock (and the option seller's obligations) can rise.
- The stock remains flat or lower than $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 of $4.75 per share that they originally collected.
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.
Essentially, a seller who sold a put option is liable to have a long stock position if the option buyer exercises.