Definition
The term naked option refers to a trading position where the seller of the option does not own any, or all, of the underlying assets specified in the contract. A trader entering into a naked option will be forced to purchase the underlying asset if notification of assignment is received.
Explanation
Also known as a naked position and an uncovered option, a naked option is one where the trader does not own all the underlying assets. The risk to the trader is the price of the security moves in a direction that is not favorable to their position. If that occurs, and the contract writer is assigned, they will be forced to purchase the underlying asset at an unfavorable price. In fact, the potential loss on a naked option is theoretically unlimited. For this reason, brokers may limit a trader's ability to enter into this position.
The two most common naked options include:
Naked Call Option: occurs when the writer sells a call, providing the holder with the right to purchase the security at the option's strike price. If the price of the underlying security increases above the strike price over the term of the option, the holder of the call will exercise their right to buy the securities. This forces the writer to purchase the securities at market, which is higher than the strike price on the call option, and sell them to the holder of the call at the strike price.
Naked Put Option: occurs when the writer sells a put, providing the holder with the right to sell the security at the option's strike price. If the price of the underlying security decreases below the strike price over the term of the option, the holder of the put will exercise their right to sell the securities. This forces the writer to purchase the securities at the contract's strike price, which is higher than the current market price of the securities.
Related Terms
technical analysis, open outcry, married put, listed option
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