What it means
When a trader sells, or writes, an option, they take on an obligation to the buyer. A call writer must deliver shares at the strike price, and a put writer must buy shares at the strike price if the buyer exercises.
An option is covered when the writer already holds the asset or cash needed to meet that obligation, and naked when they do not. The writer's reward is the premium paid upfront, and it is the most they can make.
The risk depends on the type: a naked call has an unlimited loss, because a share price can rise without a ceiling, while a naked put has a large but limited loss, because a share price cannot fall below zero. Brokers treat naked options as high risk.
They typically demand approval at the highest options trading level, a minimum account size and substantial margin. Margin requirements are recalculated daily, so a sharp move can mean an urgent request for more money.
Some people write naked options because they want to earn income in calm markets, or because they hold a strong view on direction. Others use them as part of a larger strategy where another position offsets part of the risk, though at that point they may no longer be truly naked.
For a business reader, the key point is that the term describes a risk shape, not a particular product. Whenever you hear that a position is naked, ask what could go wrong and how large the loss could be, because the answer is usually much bigger than the income being earned.
In practice
Real-world examples.
Example
A retail investor with options approval sells a naked put on a large bank for $1.50 a share. When the bank reports a surprise loss and the share drops 20%, his broker issues a margin call and he has to deposit extra cash.
Example
A proprietary trading desk sells naked calls on an index of mid-sized companies as part of a short-term volatility view. The desk sets a hard stop-loss so that any single position cannot cost more than $250,000.
Example
A corporate finance director discovers during an audit that a subsidiary's treasury clerk had written naked options on commodities. The company bans the practice immediately and adds options to the list of products that need board approval.
Formula
Calculation
Short call profit or loss per share = Premium - the greater of (Share price - Strike price) and zero
Short put profit or loss per share = Premium - the greater of (Strike price - Share price) and zero
Multiply by 100 for a standard contract. A trader writes a naked put with a $40 strike for a $1.50 premium, collecting $150. If the share ends at $32, the loss per share is $8.00 - $1.50 = $6.50, which is $650 on the contract.
For a naked call with an $80 strike and a $3 premium, collecting $300, a finish at $95 gives a loss per share of $15 - $3 = $12, which is $1,200. In both cases the most the writer can ever earn is the premium of $150 or $300.Case study
Seen in the real world.
Kestrel Agri is an illustrative, fictional farm-supply business. Its treasury assistant, hoping to boost yields, began selling uncovered options on grain futures, earning premiums that looked like free income in quiet months.
When a drought hit, grain prices spiked and the open positions lost $620,000 in two weeks, far more than the $35,000 of premium collected. The chief financial officer only learned of the trades when the broker called about margin.
In this illustrative story the company introduced a derivatives policy requiring written approval for every new product and monthly reporting of all open positions. The incident showed that unmonitored trading creates risks that the premium never pays for.
Watch out
Common mistakes.
- Assuming naked options are only a problem for calls, when naked puts can also produce very large losses.
- Believing the premium compensates for the risk, when it is small compared with the possible loss.
- Forgetting that margin requirements rise with market moves, leaving the writer short of cash at the worst time.
Questions
People also ask.
Is a naked option the same as an uncovered option?
Yes, the terms mean the same thing: the writer has no offsetting asset or cash that covers the obligation.
Which is riskier, a naked call or a naked put?
A naked call carries unlimited theoretical loss, while a naked put's loss is capped at the strike price less the premium, so the call is generally riskier.
Can a naked option be made safer?
Yes, by buying another option as protection, which turns it into a spread with a defined maximum loss.
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