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.
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