What Is a Naked Option? How Naked Calls and Puts Work

What Is a Naked Option?

A naked option is created when the option writer or seller doesn't own any or enough of the underlying security to meet their potential obligation. Also known as an uncovered option, it doesn't provide the seller with any protection against an adverse shift in price.

Understanding a Naked Option

A naked option, also known as an uncovered option, is created when the seller of an option contract doesn't own the underlying security that's needed to meet the potential obligation that results from selling. This is also known as "writing" or "shorting" an option. The seller has no protection against an adverse shift in price. Naked options are attractive to traders and investors because their expected volatility is built into the price.

The seller of the option gets to keep any out-of-the-money (OTM) premium if the underlying security moves in the direction opposite to what the option buyer anticipated. They also get to keep the premium if it moves in the buyer's favor but not enough to account for the volatility that's already built into the price. That has typically translated to the option seller winning around 70% of trades, which can be quite appealing.

Selling an option creates an obligation at expiration for the seller to provide the option buyer with the underlying shares or futures contract for a corresponding long position for a call option or the cash necessary for a corresponding short position for a put option. The ultimate effect for a seller who sold a put option would be to create a long stock position in the option seller's account, a position purchased with cash from the option seller's account.

The seller must acquire it at expiration based on current market prices if they have no ownership of the underlying asset or the corresponding cash necessary for the execution of a put option.

Naked Calls

A trader who writes a naked call option on a stock has accepted the obligation to sell the underlying stock for the strike price at or before expiration no matter how high the share price rises. The seller will have to acquire the stock and then sell it to the option buyer to satisfy the obligation if the option is exercised and the trader doesn't own the underlying stock. The ultimate effect is that this creates a short-sell position in the option seller's account on the Monday after expiration.

Imagine a trader who believes that a stock is unlikely to rise in value over the next three months but they're not very confident that a potential decline would be very large. Assume that the stock is priced at $100 and a $105 strike call with an expiration date 90 days in the future. It's selling for $4.75 per share.

They decide to open a naked call by "selling to open" those calls and collecting the premium. The trader decides not to purchase the stock in this case because they believe the option is likely to expire worthless and the trader will keep the entire premium. 

There are two possible outcomes for a naked call trade:

1. The stock rallies before expiration: The trader has an option that will be exercised in this scenario. The option will be exercised at $105 per share because that exceeds the breakeven point for the option buyer if we assume that the stock rose to $130 on good earnings news. The trader must acquire the stock at the current market price and then sell it (or short the stock) at $105 per share to cover their obligation. These circumstances result in a $20.25 per share loss ($105 + $4.75 - $130). There's no upper limit for how high the stock and the option seller's obligations can rise.
2. The stock remains flat or lower than $105 per share at expiration: It won't be exercised if the stock is at or below the strike price at expiration. The option seller gets to keep the premium of $4.75 per share that was originally collected. 

Naked Puts

There's no limit as to how high a stock can rise so a naked call seller theoretically has unlimited risk. The seller's risk is contained with naked puts because a stock or other underlying asset can only drop to zero dollars.

A naked put option seller has accepted the obligation to buy the underlying asset at the strike price if the option is exercised at or before its expiration date. The risk is contained but it can still be quite large so brokers typically have specific rules in place regarding naked option trading. Inexperienced traders may not be permitted to place this type of order.

A seller who sold a put option is essentially liable to have a long stock position if the option buyer exercises.

The Bottom Line

Naked options are sold without any reserves to guarantee the obligation. Price changes can run rampant between the time of sale and expiration and the seller or writer doesn’t necessarily own enough or even any of the underlying security to meet their obligations. They’re highly vulnerable to loss and shouldn’t be attempted by an inexperienced trader, at least not without first getting solid, experienced advice and guidance from a professional.

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