What is a Naked Option
A naked option is created when the seller of an option contract does not currently own any, or enough, of the underlying security to meet the potential obligation that results from selling (also known as "writing" or "shorting") an option.
BREAKING DOWN Naked Option
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 positions are regarded as very risky because some positions can, in theory, lead to an unlimited loss. This is why many brokers do not allow inexperienced traders to place this type of order.
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 (or short) the stock to satisfy the obligation if the option is exercised.
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.