Naked Option
An investing term that refers to an investor selling an option without holding a corresponding position in the option’s underlying security
What is a Naked Option?
A naked option is an investing term that refers to an investor selling an option without holding a corresponding position in the option’s underlying security. Selling naked options is considered a high-risk trading practice, as it exposes the investor to high potential loss, while only providing a limited profit. Nonetheless, it is a strategy employed by many traders since most options expire as worthless. Therefore, selling options can be a profitable strategy.
Summary
- A naked option exists when the option seller does not hold a corresponding position in the option’s underlying security.
- The alternative to a naked option is a covered option. A covered option is an option sold by a seller holding a corresponding position in the underlying security. It negates the risk of selling the option but limits the seller’s potential profit in the underlying security.
- Selling naked options is considered a high-risk trading strategy.
Naked Options vs. Covered Options
As noted above, a naked option refers to selling an option when the seller does not hold a corresponding position in the underlying security. In contrast, a covered option is an option sold by a seller who does hold a corresponding position in the underlying security.
For example, if investor A already owns 100 or more shares of Stock A, and then sells a call option on the stock, he is said to be selling a covered option. Selling a covered put option would require the seller to have already established a short position in the market by selling short 100 or more shares of the underlying stock. The 100-share requirement is because standard stock options are options on 100 shares of the underlying stock.
If the option seller holds a market position of less than 100 shares, then his sale of an option would only be partially covered. Selling a covered option negates the risk of selling the option but limits the seller’s potential profit in the underlying stock to the strike price of the option.
Naked Call
The buyer of a call option is aiming to profit from a rise in the price of the option’s underlying security. A call option confers to the buyer the right to purchase a specified amount of the underlying security at the option strike price before the option’s expiration. The buyer pays a price called the “premium” to the seller of the option. The premium received for selling the option is the option seller’s maximum potential profit from the trade.
Example: Stock A is selling at $45 per share. Investor A sells a call option on the stock with a strike price of $50 to Investor B.
- If the price of Stock A remains below $50 per share until the option expires, and Investor B holds the option until expiration, then Investor A will profit in the amount of the premium received for selling the option. Investor B will lose the amount of the premium spent on buying the option.
- If the price of Stock A rises above $50 per share, then Investor B can profit in one of two ways – either by selling his option, which would have increased in value or by exercising his option. If he chooses the latter, then Investor A will lose the amount that the stock’s price is above $50, multiplied by 100 shares, minus the amount of premium he received for the option.
- It is possible for both investors to profit. If the price of Stock A rises closer to $50 per share before the option’s expiration, then Investor B can sell his option for a profit to a third party. As long as the stock price doesn’t rise above $50 before expiration, Investor A, the option seller, will still profit by the amount of the option premium.
Naked Put
The buyer of a put option is aiming to profit from a fall in the price of the option’s underlying security. A put option confers to the buyer the right to sell short a specified amount of the underlying security at the option strike price before the option’s expiration. Just as with a call option, the buyer pays a premium to the seller of the option. The premium received for selling the option is the option seller’s maximum potential profit from the trade.
Example: Stock A is selling at $50 per share. Investor A sells a put option on the stock with a strike price of $45 to Investor B.
- If the price of stock A remains above $45 per share until the option expires, and Investor B holds the option until expiration, then Investor A will profit by the amount of the premium received for selling the option. Investor B will lose the amount of the premium spent on buying the option.
- If the price of stock A declines to below $45 per share, then investor B can profit by either selling his option, which would have increased in value or by exercising his option. If he chooses the latter, then Investor A will lose the amount that the stock’s price is below $45, multiplied by 100 shares, minus the premium received for the option.
- Both investors can profit if the price of the stock declines closer to $45 per share before expiration. Investor B can sell his option for a profit, and investor A will still profit by the premium received as long as the price of the stock doesn’t fall below $45 before the option’s expiration.
More Resources
CFI offers the Commercial Banking & Credit Analyst (CBCA)™ certification program for those looking to take their careers to the next level. To keep learning and developing your knowledge base, please explore the additional relevant resources below:
