WHAT ARE NAKED OPTIONS?

 

Naked Options: an in-depth explanation

 

   Naked options refer to a high-risk strategy in options trading where the trader sells options without owning the underlying asset or holding a position that would offset potential losses. This type of strategy is considered speculative and risky because the seller (also known as the "writer") is exposed to theoretically unlimited risk if the market moves against their position.

 

To fully grasp the concept of naked options, it's important to first understand how options trading works.

 

What Are Options?

 

Options are financial contracts that give the buyer the right (but not the obligation) to buy or sell an underlying asset at a specified price, known as the strike price, before or on a specific expiration date. There are two types of options:

 

Call option:  This gives the buyer the right to buy the underlying asset.

 

Put option:  This gives the buyer the right to sell the underlying asset.

 

   Each option contract typically controls 100 shares of the underlying asset, whether it's a stock, bond, index, or commodity. Options are used for various purposes, including hedging, speculation, and income generation.

 

What Does "Naked" Mean?

 

In options trading, a position is considered "naked" when the seller of the option does not own the underlying asset or hold any other positions to mitigate potential losses. Naked options can be written for both calls and puts:

 

Naked call:  The seller (writer) of a naked call option does not own the underlying asset, yet they are obligated to sell the asset at the strike price if the buyer exercises the option. This exposes the seller to unlimited risk if the asset's price rises substantially.

 

Naked put:  In a naked put, the seller does not have the cash set aside to buy the asset at the strike price if the buyer decides to exercise the option. If the price of the underlying asset falls significantly, the seller may be forced to buy the asset at a much higher price than its market value, incurring losses.

 

Example of naked call option

 

Let’s say you write a naked call option on a stock that is trading at $100, with a strike price of $110. You receive a premium of $5 for selling the option. Here are the two possible scenarios:

 

The stock price stays below Rs.110:  In this case, the buyer will not exercise the option since they wouldn’t want to buy the stock for Rs.110 when it's trading below that. The option expires worthless, and you keep the Rs.5 premium.

 

The stock price rises above Rs.110:  If the stock price rises to, say, Rs.130, the buyer will exercise the option, forcing you to sell the stock to them at Rs.110. However, since you don’t own the stock, you’ll have to purchase it from the market at the current price of Rs.130, resulting in a loss of Rs.20 per share (minus the premium you received). The higher the stock price goes, the more you lose.

 

This is why naked call options are considered extremely risky—theoretically, there’s no limit to how high a stock’s price can go, meaning there is unlimited potential for loss.

 

Example of naked put option

 

Imagine you write a naked put option on a stock trading at $100 with a strike price of $90, and you receive a $5 premium. Here’s what can happen:

 

The stock price stays above Rs.90:  The buyer will not exercise the option because it would make no sense to sell the stock for Rs.90 when the market price is higher. You keep the premium of Rs.5, and the option expires worthless.

 

The stock price falls below Rs.90:  If the stock price drops to Rs.70, the buyer will exercise the option, forcing you to buy the stock at Rs.90. You will be left holding an asset that’s worth significantly less in the market, resulting in a loss of Rs.20 per share (minus the premium you received). In this scenario, your loss is limited because a stock’s price can’t go below zero, but the loss can still be substantial.

 

Naked Options vs. covered options

 

A "covered" option refers to an option where the writer holds a corresponding position in the underlying asset that covers their obligations. For example:

 

Covered call:  The seller owns the stock they are obligated to sell, thereby limiting their risk.

 

Covered put:  The seller has the cash on hand to buy the stock if the option is exercised.

 

In contrast, naked options do not have this built-in protection, which is why they are much riskier.

 

Risks involved with naked options

 

The primary reason why naked options are considered risky is the potential for unlimited loss:

 

Naked call risk:  When you write a naked call, there is no upper limit to how high the underlying asset's price can rise. For example, if a stock experiences a sudden surge in value, the seller is forced to buy the stock at the new high price to deliver it at the strike price, resulting in large losses.

 

Naked put risk:  While the risk of a naked put is limited to the price of the underlying asset dropping to zero, the losses can still be substantial. A market crash or an unexpected event can cause the stock to plummet, forcing the seller to buy shares at a higher price than the current market price.

 

Margin requirements:  Naked options require significant margin deposits to cover potential losses. Since there is theoretically no limit to how much a naked option can lose, brokers often require high margin requirements to mitigate their own risks. If the market moves sharply, traders may face margin calls, forcing them to deposit more funds or sell other positions to cover losses.

 

Why Would Someone Write Naked Options?

 

Despite the risks, traders write naked options for potential rewards. The primary incentive is the premium received from selling the option. Here are some reasons traders might use this strategy:

 

Speculation:  Some traders believe they can predict market movements and take advantage of a perceived opportunity by writing naked options. For example, if they believe a stock won’t rise above a certain level, they might write a naked call to capture the premium.

 

Income generation:  Selling options can provide a steady stream of income from premiums. Some traders use naked options as part of a broader strategy to generate consistent returns, even though they accept the higher risks.

 

Short-term moves:  Experienced traders sometimes write naked options when they expect short-term price movements to remain in a narrow range, hoping to collect premiums from options that expire worthless.

 

Who Should Avoid Naked Options?

 

Naked options are not suitable for beginner traders or those with a low tolerance for risk. Here are some reasons why traders might avoid this strategy:

 

Lack of experience:  Trading naked options requires a deep understanding of market dynamics, options pricing, and risk management. Beginners often underestimate the potential risks involved.

 

High-risk tolerance:  Because losses can be catastrophic, this strategy is generally only suitable for traders with significant risk tolerance and a willingness to withstand potentially large drawdowns.

 

Margin risk:  Margin calls can force traders to liquidate other positions, which could worsen losses if the market moves quickly against them.

 

Conclusion

   Naked options are a high-risk, high-reward strategy that involves selling options without owning the underlying asset or having a protective position. While the potential to earn premiums can be appealing, the risk of substantial and even unlimited losses makes this strategy suitable only for experienced traders with a high tolerance for risk. Understanding market conditions, proper risk management, and having a well-thought-out exit strategy are critical for anyone considering naked options as part of their trading approach.