A Naked Option refers to an options contract where the seller or the buyer does not hold the underlying security corresponding to that option. In simpler terms, it is an option position that is unhedged, thereby exposing the seller to potentially unlimited risk if the position moves against them.
Key Characteristics
No Underlying Security
In a naked option, the seller does not own the underlying asset. This differentiates it from a covered option, where the seller holds the actual asset to offset potential losses.
High Risk
Writing a naked option involves substantial risk. If the holder exercises the option, the writer might have to procure the underlying asset at a significantly higher price than the market rate, leading to potentially enormous financial losses.
Unlimited Loss Potential
For a naked call option, the potential loss is theoretically unlimited if the price of the underlying asset rises significantly. The risk associated with a naked put option, while also significant, is limited to the asset’s price falling to zero.
Example
Suppose an investor writes (sells) a naked call option for Company XYZ stock with a strike price of $100 per share. If the stock price surges to $150, the writer must purchase the stock at $150 to sell it at $100, incurring a loss of $50 per share (excluding the premium received).
Historical Context
Naked options have been part of financial markets for decades. However, their risk exposure came into mainstream recognition during market crashes, where traders lost substantial amounts due to unhedged positions.
Coverage in Comparison: Covered Option
Covered Option
A covered option is the opposite of a naked option, where the writer does hold the underlying security. This strategy limits risk by providing a workaround to hedge against adverse price movements in the asset.
Comparison
| Aspect | Naked Option | Covered Option |
|---|---|---|
| Underlying Security | Not held | Held |
| Risk Level | High (theoretically unlimited) | Lower (limited to underlying asset) |
| Potential Loss | Substantial, unbounded | Limited |
Related Terms
- Call Option: A call option gives the holder the right, but not the obligation, to purchase an underlying asset at a specified strike price.
- Put Option: A put option grants the holder the right, but not the obligation, to sell an underlying asset at a specified strike price.
- Derivative: A derivative is a financial instrument whose value depends on the value of an underlying asset, such as stocks, bonds, commodities, or currencies.
FAQs
What is the main risk of a naked option?
Are naked options suitable for beginners?
How can traders mitigate the risks of naked options?
Summary
A Naked Option represents a high-risk strategy in options trading where the writer does not hold the underlying security. This unhedged stance could lead to significant financial losses if the market price moves unfavorably. While potentially profitable, traders should approach naked options with caution and a strong understanding of the associated risks.
References
- Hull, J. C. (2018). Options, Futures, and Other Derivatives. Pearson.
- McMillan, L. G. (2002). Options as a Strategic Investment. New York Institute of Finance.
- Natenberg, S. (1994). Option Volatility and Pricing. McGraw-Hill.
By comprehensively understanding naked options, investors can make more informed decisions aligned with their risk tolerance and investment strategy.
