What is a 'Naked Position'

A naked position is a securities position, long or short, that is not hedged from market risk. Both the potential gain and the potential risk are greater when a position is naked instead of covered or hedged in some way.

For example, a naked stock position does not have the hedging associated with a call or put option or perhaps an opposite position in a related stock. For example, a long in Coke and a short in Pepsi.

BREAKING DOWN 'Naked Position'

A naked position is inherently risky because there is no protection against an adverse move. Most investors do not consider owning stocks to be excessively risky, especially because in most cases it is easy to sell the position back to the market. However, a declining market for an investor holding a long position in a stock still has the potential to deliver significant losses. In this case, holding a put option against the long stock position could, for a small price, cap losses to a manageable amount.

The investor's profit potential, before commissions, would be reduced by the premium, or cost, of the option. Consider it to be an insurance policy the investor hopes never to use.

Investors selling stocks short without hedges face even greater risk since the upside potential for a stock is theoretically unlimited. In this case, owning a call on the underlying stock would limit that risk.

Naked Options

In the options market, uncovered or naked calls and puts also have risk. In this case, it is the options seller, or writer, that has unhedged risk. Options buyers only risk the amount paid to buy the options, which is normally significantly less than the amount needed to purchase actual shares of stock or another underlying asset.

Options sellers, on the other hand, can have unlimited risk if not hedged. For example, an investor sells a call option on a stock and that stock soars higher in price before expiration. The options buyer could likely exercise the option, forcing the seller to go out into the open market to buy the stock at the higher price in order to deliver it to the options buyer. If the options seller owned an offsetting position in the underlying stock, his or her risk would be limited.

Put sellers would have nearly unlimited risk should the underlying stock fall towards zero. A corresponding short position in the underlying stock would limit that risk.

However, in more practical terms, the seller of uncovered puts or calls, will likely repurchase them well before the price of the underlying security moves adversely too far away from the strike price, based on their risk tolerance and stop loss settings.

More advanced options traders can hedge risk with multiple positions of puts and calls, called combinations.

RELATED TERMS
  1. Naked Put

    A naked put is an options strategy in which the investor writes ...
  2. Naked Call

    A naked call is an options strategy in which the investor writes ...
  3. Covered Bear

    A trading strategy in which a short sale is made on a long position. ...
  4. Hedging Transaction

    A hedging transaction is a position that an investor enters to ...
  5. Covered Writer

    Covered writers are investors that limit risk by owning the underlying ...
  6. Basis Risk

    Basis risk is the risk that offsetting investments in a hedging ...
Related Articles
  1. Managing Wealth

    Offset Risk With Options, Futures And Hedge Funds

    Though all portfolios contain some risk, there are ways to lower it. Find out how.
  2. Trading

    Hedging basics: What is a hedge?

    Hedging is a widely misunderstood strategy, but it's not as complicated as you might think.
  3. Investing

    What Drives Ford's Profits? Not Just Cars

    Ford, an experienced legacy car manufacturer, sells a lot of cars around the world and makes a lot of money in the money lending and leasing business.
  4. Investing

    For Maximum Market Returns, Get Creative With Hedges

    Proper hedges help to contain your losses while still allowing profits to grow.
  5. Managing Wealth

    Practical And Affordable Hedging Strategies

    Hedging offers a cost-effective way to transfer risk.
  6. Investing

    The multiple strategies of hedge funds

    Current and potential hedge fund investors need to understand how much risk hedge funds take on in order to make money.
  7. Investing

    Hedging With ETFs: A Cost-Effective Alternative

    The benefits of ETFs for hedging are numerous and can be enjoyed by investors of all sizes.
  8. Trading

    Trade The Covered Call - Without The Stock

    The standard covered call can be used to hedge positions or generate income. This calendar spread may do so more effectively.
  9. Investing

    Top 5 Companies Owned by Ford

    Discover some of Ford Motor Company's most important subsidiaries and joint ventures, and learn more about what they do to further Ford's business interests.
RELATED FAQS
  1. What is the difference between shorting and naked shorting?

    Short selling involves borrowing shares of a company’s stock and selling it with the hopes it can be bought back at ... Read Answer >>
Hot Definitions
  1. Inflation

    Inflation is the rate at which prices for goods and services is rising and the worth of currency is dropping.
  2. Discount Rate

    Discount rate is the interest rate charged to commercial banks and other depository institutions for loans received from ...
  3. Economies of Scale

    Economies of scale refer to reduced costs per unit that arise from increased total output of a product. For example, a larger ...
  4. Quick Ratio

    The quick ratio measures a company’s ability to meet its short-term obligations with its most liquid assets.
  5. Leverage

    Leverage results from using borrowed capital as a source of funding when investing to expand the firm's asset base and generate ...
  6. Financial Risk

    Financial risk is the possibility that shareholders will lose money when investing in a company if its cash flow fails to ...
Trading Center