![Short call option](https://upload.wikimedia.org/wikipedia/commons/5/5e/Short_call_option.svg)
A naked option or uncovered option is an
options contract where the option writer (i.e., the seller) does not hold the underlying
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position to cover the contract in case of assignment (like in a
covered option
A covered option is a financial transaction in which the holder of securities sells (or "writes") a type of financial options contract known as a " call" or a " put" against stock that they own or are shorting. The seller of a covered option re ...
). Nor does the seller hold any option of the same class on the same underlying security that could protect against potential losses (like in an
options spread
Options spreads are the basic building blocks of many options trading strategies. A spread position is entered by buying and selling options of the same class on the same underlying security but with different strike prices or expiration dates. A ...
). A naked option involving a "
call
Call or Calls may refer to:
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* Call, a type of betting in poker
* Call, in the game of contract bridge, a bid, pass, double, or redouble in the bidding stage
Music and dance
* Call (band), from Lahore, Paki ...
" is called a "naked call" or "uncovered call", while one involving a "
put" is a "naked put" or "uncovered put".
The naked option is one of riskiest
options strategies
Option strategies are the simultaneous, and often mixed, buying or selling of one or more options that differ in one or more of the options' variables. Call options, simply known as Calls, give the buyer a right to buy a particular stock at that ...
, and therefore most brokers restrict them to only those traders that have the highest options level approval and have a
margin account
In finance, margin is the collateral that a holder of a financial instrument has to deposit with a counterparty (most often their broker or an exchange) to cover some or all of the credit risk the holder poses for the counterparty. This risk ...
. Naked option are attractive because the seller receives the premium cost of the option without buying a corresponding position to hedge against potential losses. In the case of a naked put, the seller hopes that the underlying equity or stock price stays the same or rises. In the case of a naked call, the seller hopes that the underlying equity or stock price stays the same or drops. And the seller's odds of retaining the premium at expiration increase the further the naked option is
out of the money
In finance, moneyness is the relative position of the current price (or future price) of an underlying asset (e.g., a stock) with respect to the strike price of a derivative, most commonly a call option or a put option. Moneyness is firstly a thr ...
at the time it was written.
Selling a naked option could also be used as an alternative to using a
limit order
An order is an instruction to buy or sell on a trading venue such as a stock market, bond market, commodity market, financial derivative market or cryptocurrency exchange. These instructions can be simple or complicated, and can be sent to either ...
or
stop order to open an equity position. Instead of buying an underlying stock outright, one with sufficient cash could sell a put option, receive the premium, and then buy the stock if its price drops to or below the
strike price
In finance, the strike price (or exercise price) of an option is a fixed price at which the owner of the option can buy (in the case of a call), or sell (in the case of a put), the underlying security or commodity. The strike price may be set ...
at assignment or expiration. Likewise, one with sufficient equity to borrow on margin could sell a call option, receive the premium, and then short the stock if its price rises to or above the strike price at assignment or expiration.
However, the naked option has the highest risk because sellers have agreed to cover the contract in case of assignment, no matter how far the price of the stock goes. The seller of a naked put would be obligated to purchase the underlying stock at the strike price even if its market price drops down to zero. Likewise, the seller of a naked call could be forced to short the underlying stock at the strike price even if its market price rises up to an unlimited amount. Because nothing is covered to protect against potential losses, a
margin call
''Margin Call'' is a 2011 American drama film written and directed by J. C. Chandor in his feature directorial debut. The principal story takes place over a 24-hour period at a large Wall Street investment bank during the initial stages of the ...
would be triggered if the seller does not have enough equity or cash to cover the contract in case of assignment.
Examples
Naked call example
Shares of XYZ is currently selling at $85 per share and Speculator A decides to sell the right to own 100 shares of XYZ (call option) at a strike price of $100 per share on or before May 10 for $24. If the XYZ shares fail to rise above $100 before May 10, the call option expires worthless and Speculator A makes a profit of $24. However, if the XYZ shares rise above $100, Speculator A would be obligated to buy 100 shares of XYZ at
market price
A price is the (usually not negative) quantity of payment or compensation given by one party to another in return for goods or services. In some situations, the price of production has a different name. If the product is a "good" in the ...
and sell them back for $100 each. In this scenario, the Speculator A makes a loss of (100 * XYZ market price) - (100 * $100) - $24. As market price can rise an unlimited amount, Speculator A can experience unlimited losses in this 'worst case' scenario.
Naked put example
Shares of XYZ is currently selling at $85 per share and Speculator A decides to buy the right to own 100 shares of XYZ (put option) at a strike price of $75 per share on or before June 17 for $24. If the XYZ shares fail to drop below $75 before June 10, the put option expires worthless and Speculator A makes a profit of $24. However, if the XYZ shares drop at or below $75, Speculator A would still be obligated to buy 100 shares of XYZ at a price of $75, even if the market price drops at or near $0.
References
Further reading
*Mark D. Wolfinger, "The Rookie's Guide to Options" The Beginner's Handbook of Trading Equity Options" W&A Publishing, Cedar Falls, 2008.
External links
Chicago Board Options ExchangeInvestopedia Options tutorial
{{Derivatives market
Options (finance)