Naked options are a type of option strategy where the investor does not hold a position in the underlying asset. This options strategy can be a way to make money for nothing, or—as recent history has shown with the Gamestop frenzy of early 2021—a way to suffer incredible trading losses.
What is a Naked Option?
A naked, or “uncovered,” option is an option that is issued and sold without the seller setting aside any shares or cash to meet the obligation of the option when it reaches expiration.
When an investor buys an option, they’re buying the right to buy or sell a security at a specific price either on or before the option contract’s expiration. An option to buy is known as a “call” option, while an option to sell is known as a “put” option.
Investors who buy options pay a premium for the privilege. To collect those premiums, there are investors who write options. Some hold the stock or the cash equivalent of the stock they have to deliver at the option’s expiration. The ones who don’t are sometimes called naked writers, because their options have no cover.
Naked writers are willing to take that risk because the terms of the options factor in the expected volatility of the underlying security. This differs from options based on the price of the security at the time the option is written. As a result, the underlying security will have to not only move in the direction the holder anticipated, but do so past a certain point for the holder to make money on the option.
Recommended: A Guide to Options Trading
The Pros and Cons of Naked Options
There are risks and rewards associated with naked options. It’s important to understand both sides.
Naked Writers Often Profit
The terms of naked options have given them a track record in which the naked writer tends to come out on top, walking away with the entire premium. That’s made writing these options a popular strategy.
Those premiums vary widely, depending on the risks that the writer takes. The more likely the broader market believes the option will expire “in the money” (with the shares of the underlying stock higher than the strike price), the higher the premium the writer can demand.
But Sometimes the Options Holder Wins
When an option writer sells an option, they’re obligated to deliver the underlying securities (in the case of a call option) or cash (in the case of a put) to the option holder at expiration. But because a naked writer doesn’t hold the securities or cash, they need to buy it or find it if the option they wrote is in the money, meaning that the investor exercises the option for a profit.
In cases where the naked writer has to provide stock to the option holder at a fixed price, the strategy of writing naked call options can be disastrous. That’s because there’s no limit to how high a stock can go between when a call option is written and when it expires.
Naked Options in Recent Headlines
The high-profile trading drama surrounding the stock of video game retailer GameStop showcased some of the danger of naked options. As the stock soared to a peak of $483 per share in late January of 2021, there were naked call options in the hands of investors that entitled them to buy the stock for $87 per share.
While that sounds like great news for the options holders, it had the potential to be catastrophic for the naked writer—because they’d have to find the money to buy the stock to cover those options. And because they weren’t holding the stock during its runup, they would have to either go into their cash reserves or sell other investments to buy the stock they were required to deliver.
But during that period of wild trading in GameStop, naked writers were still at work. With the stock trading at nearly $200, naked options writers sold 33,000 put options betting the stock would close at under fifty cents in the near future. Those writers potentially stood to pocket the entire premium.
How to Use Naked Options
While there are some large institutions whose business focuses on writing options, some individual investors can also write options.
Because naked call writing comes with almost limitless risks, brokerage firms only allow high-net-worth investors with hefty account balances to do it. Some will also limit the practice to wealthy investors with a high degree of sophistication. To get a better sense of what a given brokerage allows in terms of writing options, these stipulations are usually detailed in the brokerage’s options agreement. The high risks of writing naked options are why many brokerages apply very high 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 that the investor would write the naked call option. An investor would do this if they expected the stock to go down, or at least not go any higher than the volatility written into the option contract.
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 profound.
This is why some investors, when they think a stock is likely to drop, are more likely 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
Because writing naked options comes with potentially unlimited risk, most investors who employ the strategy will also use risk-control strategies. 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. The 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 the sellers of fifty-cent GameStop put options when the stock was trading in the $190 range. By setting the strike prices so far from where the current market was trading, they limited their risk. That’s because the market would have to do something quite dramatic for those options to be in the money at expiration.
With naked options, the investor does not hold a position in the underlying asset. Because this is a risky move, brokerage firms may allow their high-net-worth investors to write naked options.
Investors looking to take an active role in their investments might consider opening an account with SoFi Invest®. With SoFi Invest, members can trade stocks, ETFs, crypto, and may participate in upcoming IPOs.
The information provided is not meant to provide investment or financial advice. Investment decisions should be based on an individual’s specific financial needs, goals and risk profile. SoFi can’t guarantee future financial performance. Advisory services offered through SoFi Wealth, LLC. SoFi Securities, LLC, member FINRA / SIPC . SoFi Invest refers to the three investment and trading platforms operated by Social Finance, Inc. and its affiliates (described below). Individual customer accounts may be subject to the terms applicable to one or more of the platforms below.
1) Automated Investing—The Automated Investing platform is owned by SoFi Wealth LLC, an SEC Registered Investment Advisor (“Sofi Wealth“). Brokerage services are provided to SoFi Wealth LLC by SoFi Securities LLC, an affiliated SEC registered broker dealer and member FINRA/SIPC, (“Sofi Securities).
2) Active Investing—The Active Investing platform is owned by SoFi Securities LLC. Clearing and custody of all securities are provided by APEX Clearing Corporation.
3) Cryptocurrency is offered by SoFi Digital Assets, LLC, a FinCEN registered Money Service Business.
For additional disclosures related to the SoFi Invest platforms described above, including state licensure of Sofi Digital Assets, LLC, please visit www.sofi.com/legal. Neither the Investment Advisor Representatives of SoFi Wealth, nor the Registered Representatives of SoFi Securities are compensated for the sale of any product or service sold through any SoFi Invest platform. Information related to lending products contained herein should not be construed as an offer or pre-qualification for any loan product offered by SoFi Lending Corp and/or its affiliates.
Third Party Brand Mentions: No brands or products mentioned are affiliated with SoFi, nor do they endorse or sponsor this article. Third party trademarks referenced herein are property of their respective owners.
Crypto: Bitcoin and other cryptocurrencies aren’t endorsed or guaranteed by any government, are volatile, and involve a high degree of risk. Consumer protection and securities laws don’t regulate cryptocurrencies to the same degree as traditional brokerage and investment products. Research and knowledge are essential prerequisites before engaging with any cryptocurrency. US regulators, including FINRA , the SEC , and the CFPB , have issued public advisories concerning digital asset risk. Cryptocurrency purchases should not be made with funds drawn from financial products including student loans, personal loans, mortgage refinancing, savings, retirement funds or traditional investments.
IPOs: Investing early in IPO stock involves substantial risk of loss. The decision to invest should always be made as part of a comprehensive financial plan taking individual circumstances and risk appetites into account.
Exchange Traded Funds (ETFs): Investors should carefully consider the information contained in the prospectus, which contains the Fund’s investment objectives, risks, charges, expenses, and other relevant information. You may obtain a prospectus from the Fund company’s website or by email customer service at [email protected] Please read the prospectus carefully prior to investing. Shares of ETFs must be bought and sold at market price, which can vary significantly from the Fund’s net asset value (NAV). Investment returns are subject to market volatility and shares may be worth more or less their original value when redeemed. The diversification of an ETF will not protect against loss. An ETF may not achieve its stated investment objective. Rebalancing and other activities within the fund may be subject to tax consequences.