Options are complex financial contracts that are based on the value of an underlying asset, such as a stock, bond, or commodity among others. An options contract allows the buyer the right (but not the obligation) to buy or sell the underlying asset at a certain price by the contract's expiry date. Traders can use options as part of their strategies to hedge or speculate on the price movements of the underlying assets. But, there may be instances when carrying a certain position creates unlimited liability. In this article, we look at how selling naked options carry this risk.
Key Takeaways
- Naked options allow but don't obligate the contract writer to buy or sell the underlying asset at an agreed-upon price by the expiry date.
- With naked options, the writer doesn't own the underlying asset.
- There is an unlimited risk of loss associated with selling naked calls if the price of the underlying asset shifts course.
- Naked puts come with the potential for losses even though the underlying asset's price can drop as low as $0.
What Are Naked Call and Put Options?
A naked option is a type of options contract that is uncovered. This means that the trader doesn't own any (or enough of) the underlying asset to cover their obligation if the contract is exercised upon expiry. Put simply, if the other party decides to take delivery of the underlying asset, such as a stock or bond, the seller isn't able to transfer all or part of the contract order.
Naked Calls
Naked calls are options contracts where the trader agrees to sell the underlying asset to the buyer at the agreed-upon price before or at the expiry date regardless of the asset's price. Traders take a naked call position when they believe the price of the asset will trade below the contract price upon expiry.
Since the writer doesn't own the asset, they must purchase the allotted amount (say, 100 shares in Company X) and transfer them to the buyer when the contract expires to fulfill their obligation. Naked or uncovered calls create short positions in the seller's account if they're exercised.
Naked Puts
With naked puts, the seller agrees to (but isn't obligated) to buy the underlying asset at a certain price by the expiry date. Also called uncovered puts, naked put options work under the assumption that the price of the underlying asset will change and ultimately rise over a few months.
Like the naked call, the contract holder doesn't own any or enough of the underlying asset to transfer if the contract is exercised. This type of option creates a long position if the option is exercised.
The agreed-upon price in an options contract is called the strike price.
Liability Risks of Selling Naked Call and Put Options
Selling Naked Call Options
When a trader sells a call option, they typically do so against existing stock holdings in an attempt to create income from the position by capturing a premium. But, selling naked calls creates unlimited liability. Therefore, this type of option strategy is considered appropriate for sophisticated traders with proper risk management and discipline.
Here's why: When a trader sells naked call options, the risk is theoretically unlimited. Suppose a trader sells calls on a company that trades for $10. They believe the upside is limited for the company and sell 100 calls at a strike price of $15 for $1. From this sale, the trader collects $10,000.
But, it turns out that the trader's judgment is incorrect, and a competitor buys out the stock for $50. All of a sudden, the call options that the trader is short climb to $35 even though they sold them for $1. Their $10,000 profit would turn into a $350,000 loss. This example illustrates the dangers of naked selling call options.
Selling Naked Put Options
There is also the potential for unlimited losses with naked put options. Selling naked put options can be quite dangerous in the event of a steep fall in the price of a stock. The option seller is forced to buy the stock at a certain price.
However, the lowest the stock can drop to is zero, so there is a floor to the losses. In the case of call options, there is no limit to how high a stock can climb, meaning that potential losses are limitless.
How to Avoid Liability with Options
Let's assume that a trader owns 1,000 shares of Apple (AAPL) which trades at $125. The trader sells 10 calls at a strike price of $150 for $2. Each option contract represents 100 shares, so the sale nets the trader $2,000.
If Apple climbs above $150, the trader must sell his position or buy back the options. If Apple does not climb above that level by the option's expiration date, the trader can hold onto their shares and pocket the premium. Owning the shares takes the risk away from this strategy.
What Is a Naked Option?
Naked options are one kind of options contract. As such, they allow but don't obligate the writer to buy or sell the underlying asset at an agreed-upon price by the expiry date. But unlike with regular options, the writers of naked options don't own the underlying asset. This means that if the other party decides to exercise the option, they must purchase the asset and deliver it to fulfill their obligation. Naked options are also called uncovered options because they aren't covered by the underlying asset.
How Do Options Work?
Options are financial contracts that give the holder the right (but not the obligation) to buy or sell an underlying asset at an agreed-upon date before or when the contract expires. Options are based on the value of an asset like a stock, bond, exchange-traded fund (ETF), commodity, currency, and index among others. Call options give the holder the right to buy the underlying asset while put options allow the contract writer the right to sell the underlying asset.
What Are the Risks Associated With Naked Options?
Writing naked options comes with several risks. These calls are uncovered, which means the contract holder doesn't own the underlying asset on which the contract is based. So if the other party decides to exercise the option, the writer must purchase the asset and deliver it to the other party. There is also the risk of losses. Traders may also realize losses if the price of the underlying asset of a naked option moves in the opposite direction.
The Bottom Line
Naked options can be a great way to realize profits. But they do come with a lot of risk. That's because you put yourself up against unlimited losses if the price of the underlying asset takes a drastic shift from where you originally expected as shown in our example above. As such, these financial instruments should only be used by experienced traders who are able to manage and tolerate the risk that comes with them.
