Editor's Note: Options are not suitable for all investors. Options involve risks, including substantial risk of loss and the possibility an investor may lose the entire amount invested in a short period of time. Please see the Characteristics and Risks of Standardized Options.
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A naked (or uncovered) option is an option that is issued and sold without the seller owning the underlying asset or reserving the cash needed to meet the obligation of the option if exercised.
While an options writer (or seller) collects a premium upfront for naked options, they also assume the risk of the option being exercised. If exercised, they’re obligated to deliver the underlying securities at the strike price (in the case of a call option) or purchase the underlying securities at the strike price (in the case of a put).
But because a naked writer doesn’t hold the securities or cash to cover the option they wrote, they need to buy the underlying asset on the open market if the option moves into the money and is assigned, making them naked options. Given the extreme risk of naked options, they should only be used by investors with a very high tolerance for risk.
Key Points
• Naked options involve selling options without owning the underlying asset or reserving cash to cover the trade if the option is exercised.
• Naked options are extremely high risk due to unlimited potential losses if the market moves against the position.
• Naked options sellers must have a margin account and meet specific requirements to trade naked options.
• Naked options strategies include selling calls and puts to try to generate income.
• Using risk management strategies is essential to try to mitigate the significant risk of loss associated with naked options.
What Is a Naked Option?
When an investor buys an option, they’re buying the right (but not the obligation) to buy or sell a security at a specific price either on or before the option contract’s expiration. An option giving a buyer the right to purchase the underlying asset is known as a “call” option, while an option giving a buyer right to sell the underlying asset is known as a “put” option.
Investors pay a premium to purchase options, while those who sell, or write options, collect the premiums. Some writers hold the stock or the cash equivalent needed to fulfill the contract in case the option is exercised before or on the day it expires. The ones who don’t are sometimes called naked writers, because their options have no cover.
Writing naked options is extremely risky since losses can be substantial and even theoretically infinite in the case of writing naked calls. The maximum gain naked option writers may see, meanwhile, is the premium they receive upfront.
Despite the risks, some writers may consider selling naked options to try to collect the premium when the implied volatility of the underlying asset is low and they believe it’s likely to stay out of the money. In these situations, the goal is often to try to take advantage of stable conditions and reduced assignment risk, even if premiums are smaller, though there is still a high risk of seeing losses.
Some naked writers traders may be willing to risk writing naked options when they believe the anticipated volatility for the underlying asset is higher than it should be. Since volatility drives up options’ prices, they’re betting that they may receive a higher premium while the asset’s market price remains stable. This is an incredibly risky maneuver, however, since they stand to see massive losses if the asset sees bigger price swings and moves into the money.
Recommended: A Guide to Options Trading
The Pros and Cons of Naked Options
Naked options offer writers the potential to profit from premiums received, but they come with a high risk of resulting in substantial losses. Here’s what to consider before using this advanced strategy.
Potential benefits of naked options
Premium income: Option writers collect premiums upfront, which can generate income if the contract expires worthless.
No capital tied up in the underlying asset: Because the writer doesn’t hold the underlying asset, their available capital may be invested elsewhere.
May appeal in low-volatility markets: While options writers often seek higher premiums during periods of elevated volatility, naked options may be attractive to some when implied volatility is low and premiums are relatively stable. This is because the price of the underlying asset may be less likely to see bigger price movements and move into the money. There is always the possibility, however, that the asset’s price could move against them.
Significant risks of naked options
Unlimited loss potential: For naked calls, a rising stock price can create uncapped losses if the writer must buy at market value. Naked puts can also lead to significant losses if the stock price falls sharply, obligating the writer to purchase shares at a strike price that is well above market value.
Margin requirements: Brokerages often require high levels of capital and may issue margin calls if the position moves against the writer.
Limited to experienced investors: Most brokerages restrict this strategy to individuals who meet strict approval criteria due to its complexity and risk.
Recommended: 10 Options Strategies You Should Know
How to Use Naked Options
Because naked call writing comes with almost limitless risks, brokerage firms typically require investors to meet strict margin requirements and have enough experience with options trading to do it. Check the brokerage’s options agreement, which typically outlines the requirements for writing options. The high risks of writing naked options are why many brokerages apply higher maintenance margin requirements for option-writing traders.
Generally, to sell a naked call option, for example, an investor would tell their broker to “sell to open” a call position. This means the investor is initiating the short call position. The trade is considered to be “naked” only if they do not own the underlying asset. An investor would do this if they expected the stock to go down, or at least not go any higher than the volatility priced into the option contract price.
If the investor who writes a naked call is right, and the option stays “out of the money” (meaning the security’s price is below a call option’s strike price), then the investor will pocket a premium. But if they’re wrong, the losses can be theoretically unlimited.
This is why some investors, when they expect a stock to decline, may instead choose to purchase a put option and pay the premium. In that case, the worst-case scenario is that they lose the amount of the premium and no more.
How to Manage Naked Option Risk
Most investors who employ the naked options strategy will also use risk-control strategies given the high risk associated with naked options.
Perhaps the simplest way to hedge the risk of writing the option is to either buy the underlying security, or to buy an offsetting option that would create an option spread, which may help limit potential losses if the trade moves against the writer. This would change the position from being a naked option to a covered option.
Some investors may also use stop-loss orders or set price-based exit points to try to close out a position before assignment, though this requires monitoring and quick execution. These strategies aim to exit the option before it becomes in-the-money and is assigned. Other risk-mitigation strategies can involve derivative instruments and computer models, and may be too time-consuming for most investors.
Another important way that options writers try to manage their risk is by being conservative in setting the strike prices of the options. Consider an investor selling a put option with a $90 strike price when the stock is trading at $100 (for a premium of say $0.50). Setting the strike price further from where the current market is trading may help reduce their risk. That’s because the market would have to move dramatically for those options to be in the money at expiration.
💡 Quick Tip: All investments come with some degree of risk — and some are riskier than others. Before investing online, decide on your investment goals and how much risk you want to take.
The Takeaway
With naked options, the investor does not hold a position in the underlying asset. Because this is a risky move, brokerage firms typically restrict it to high-net-worth investors or experienced investors, and they also require a margin account. It’s crucial that investors fully understand the very high risk of seeing substantial losses prior to considering naked options strategies.
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With SoFi Invest® online options trading, there are no contract fees and no commissions. Plus, SoFi offers educational support — including in-app coaching resources, real-time pricing, and other tools to help you make informed decisions, based on your tolerance for risk.
FAQ
What is a naked option?
A naked option is a type of options contract where the seller does not hold the underlying asset, nor has sufficient cash reserved to fulfill the contract if exercised. This exposes the seller to potentially unlimited losses. Naked calls and puts are typically permitted only for experienced investors with high risk tolerance and margin approval.
What is an example of an uncovered option?
A common example of an uncovered, or naked, option is a call option sold by an investor who doesn’t own the underlying stock. If the stock price rises significantly and the option is exercised, the seller must buy shares at market price to deliver them, which can result in substantial losses.
Why are naked options risky?
Naked options are risky because the seller has no protection if the market moves against them. Without owning the underlying asset or an offsetting position, losses can be substantial or even technically unlimited in the case of naked call options if the stock price rises sharply.
Can anyone trade naked options?
No, not all investors can trade naked options. Many brokerages restrict this strategy to high-net-worth individuals or experienced traders who meet strict margin and approval requirements, due to the significant risk involved.
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Options involve risks, including substantial risk of loss and the possibility an investor may lose the entire amount invested in a short period of time. Before an investor begins trading options they should familiarize themselves with the Characteristics and Risks of Standardized Options . Tax considerations with options transactions are unique, investors should consult with their tax advisor to understand the impact to their taxes.
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