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Naked Option

Updated on April 16, 2024
Article byShrestha Ghosal
Reviewed byDheeraj Vaidya, CFA, FRM

What Is Naked Option?

A naked option is an options trading type where the trader sells an options contract without owning the underlying assets. The trader sells a call or put option without hedging it. This strategy aims at earning profit from the options that expire worthless. However, this options trading’s income potential is limited.

Naked Option

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A naked option is also known as an uncovered option. It is a high-risk trading method, as the trader can incur unlimited losses. If the asset’s market price moves against the seller or if the buyer of the option decides to exercise it, the seller might have to fulfill the contract terms by purchasing or selling positions at an unfavorable price.

Key Takeaways

  • A naked option, also known as an uncovered option, is an options trading type where the trader sells an unhedged call or put option. The trader sells an options contract without owning the underlying asset in this option.
  • This high-risk options trading type has unlimited losses and limited income potential. Traders use this option for income generation through the premium amount when the options expire worthless.
  • However, if the asset price moves significantly against the seller or if the buyer of the option decides to exercise it, the seller may be forced to meet their obligation by purchasing or selling the option at an unfavorable price resulting in unlimited losses.

Naked Option Explained

A naked option, also known as an uncovered option, is an options trading type that involves selling a call or put option without hedging it. In this options type, traders sell an option contract without owning the underlying asset. It is a high-risk trading method with limited income and unlimited loss potential.

When the traders sell a naked option, they receive a premium amount from the buyer. If the options buyers do not exercise it or if the options expire worthless, the trader can keep the premium amount as profit. However, if the buyer exercises the option, the seller may be forced to sell or purchase the asset at an unfavorable price, leading to potential losses.

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Types

The naked option trading types are as follows:

#1 – Naked Call Option

A naked call option is when a trader sells a call option without owning the asset. Such traders must sell the asset at the specified strike price if the buyer of the options exercises it. If the asset price increases substantially, the seller might have to purchase the asset at a higher market price to fulfill the agreement, thus resulting in unlimited losses.

Individuals can get a clearer idea of the naked call option concept by looking at the following naked call option payoff graph:

As one can observe from the above diagram, the potential loss does not have any maximum limit if the price of the underlying asset rises above the strike price. On the other hand, the maximum possible gain that traders can earn is limited. Precisely, the maximum gains one can earn cannot exceed the premium received by the option writer upfront. Additionally, traders can determine the breakeven point by computing the sum of the call’s strike price and the option premium received initially.

#2 – Naked Put Option

A naked put option is when a trader sells a put option without having a short position in the asset. Such traders must purchase the asset at the strike price if the buyer of the option exercises it. If the asset price falls substantially, the options seller might have to buy the asset at a high market price to meet the contract terms, which could lead to unlimited losses.

Let us look at the naked put option payoff graph below to develop a comprehensive understanding of the concept.

From the above graph, it is clear that traders’ maximum potential loss is restricted, unlike in the case of naked calls. That said, although the risk is limited, one may incur significant losses. One can determine the breakeven point in this case by computing the sum of the short put strike price and the amount of premium received by the option trader. Individuals must also keep in mind that the maximum potential profit in this case, too, cannot exceed the amount of premium initially received.

Examples

Let us understand the naked option with the following examples:

Example #1

Suppose the market price for Apex Company stocks were trading at $100. John anticipated that the stock prices would decrease shortly. He wanted to benefit from this market situation, so he decided to sell a naked option contract. John set the strike price at $120 and a two months expiration period. He sold 100 shares and received a premium of $5 for each share. At expiration, the stock price stayed below the $120 strike price. As a result, the call option expired worthless. The $500 premium amount that John received was the income that he generated from trading this option.

Example #2

In January 2023, naked short selling got prohibited in the Indian securities market. Traders must fulfill their obligation by delivering the securities at the settlement period. However, the securities traded in the F&O market (Future and Options) will be eligible for short selling. The Securities and Exchange Board of India (SEBI) may periodically review the stock list suitable for short-selling transactions. This is an example of a naked option.

Benefits

The naked option strategy has the following benefits:

  • This option enables the traders to collect the premium amount upfront, which implies immediate income generation. The sellers may even be able to keep the premium amount as profit if the options expire without any value.
  • It comes with low liquidity as the sellers do not require to own the asset they are selling. As a result, the sellers can hold several positions in the market.
  • Traders can use this option to benefit from various market conditions for income generation as they offer greater flexibility.
  • In some instances, traders may use selling this option as a hedging strategy. They may sell the options against existing positions to minimize the probable losses and generate higher income.

Risks

The naked option strategy risks are as follows:

  • This options trading can lead to unlimited losses. The traders might have to purchase or sell the asset at unfavorable prices if its market prices move significantly against the seller.
  • If the buyer of the option opts to exercise their option, the seller might have to purchase or sell positions in the asset to meet the contract terms. This could lead to increased costs or risks for the options seller.
  • These options are exposed to market risks as the market conditions may impact their income potential. The asset’s price may be volatile, leading to significant losses if it moves against the seller. Furthermore, frequent price fluctuations may increase the potential risk as the seller does not own any position to mitigate losses.
  • The maximum profit the traders can earn from this option is restricted to the premium they receive.

Naked Option vs Covered Option

The differences are as follows:

Naked Options: These options, also known as uncovered options, allow traders sell an options contract without owning the asset or hedging the option. It comes with unlimited risk because the trader might have to purchase or sell the asset at unfavorable prices if the buyer exercises the options. However, these do not require high capital as the seller does not own the asset. Therefore, it is a high-risk alternative and has a higher income potential.

Covered Options: In this options type, the traders sell the options contract when they already own the asset to cover the risk. It helps the traders minimize potential losses. The risk in these options is limited as it amounts to the difference between the option’s strike price and the asset’s purchase price. It requires a high initial capital as the seller must own the asset. Therefore, it has a lower risk but a lower income potential.

Frequently Asked Questions (FAQs)

1. Are there any regulations or restrictions on naked options?

Certain restrictions and regulations may exist on this options trading depending on the exchange and the country where the investors are trading them. Specific regulatory frameworks may enforce particular rules on this options trading. Additionally, they may require the investors to fulfill particular criteria for participating in naked options trading.

2. Can naked options be traded on any underlying asset?

Investors can trade these options on an extensive underlying asset range, including commodities, currencies, stocks, exchange-traded funds (ETFs), and stock indexes. However, the options contracts availability may differ based on the options market and the underlying asset type.

3. What factors should I consider when selecting which naked options to trade?

While trading with this option, investors must consider several factors, including market volatility, liquidity, and risk appetite. Selecting options with open interest and higher trading volume ensures that the investors can easily enter or exit their positions. Furthermore, options with higher volatility have higher option premiums, implying an increased income potential. However, such options also come with higher risks.

4. Can I close a naked option position before expiration?

Yes, investors can close this option position before its expiration period by purchasing back the option they had previously sold. Closing the position leads to the cancellation of the contract and helps restrict any further losses.

This article has been a guide to what is Naked Option. Here, we explain its types, examples, benefits, risks, and compare it with covered option. You may also find some useful articles here –

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