What it means
When you sell an option, you receive a payment called the premium and take on an obligation. A call option obliges the seller to deliver shares at the agreed strike price if the buyer exercises, and a put option obliges the seller to buy shares at the strike price.
If the seller already owns the shares for a call, the option is covered; if not, it is uncovered. The danger is easiest to see with a naked call.
If the seller does not own the shares and the price jumps, the seller must buy them at the higher market price and deliver them at the lower strike price. Because a share price has no upper limit, the loss has no upper limit either.
An uncovered put has a large but limited risk. The worst outcome is that the share price falls to zero and the seller must pay the strike price for worthless shares, so the maximum loss is the strike price times the number of shares, less the premium.
That is still a very big number compared with the premium received. Because of this risk, brokers and exchanges impose strict conditions.
Sellers must have approval at a higher account level, must post margin (a deposit of cash or securities held as security), and may face margin calls (demands for more money) if the position moves against them. The margin requirement can grow quickly in a volatile market.
Sellers choose the strategy because the premium is attractive when they believe the option will expire worthless. Most of the time this belief proves right, but the occasional large loss can erase many small gains.
Risk managers therefore set position limits and stop-loss rules. It is worth comparing the strategy with simpler alternatives.
A spread, in which the seller also buys a further option to cap the loss, gives up part of the premium but removes the open-ended risk. Many firms prefer this trade-off because the worst case is known in advance.
In practice
Real-world examples.
Example
A private investor sells an uncovered call on 500 shares at a strike of $40, collecting $1,000 in premium. A takeover bid pushes the share price to $60, and the investor faces a loss of $10,000 less the premium, or $9,000.
Example
An options trading desk sells uncovered puts on an index and sets a firm loss limit of $250,000. When the index falls sharply, the risk team closes the position at the limit instead of waiting for a recovery. The desk then reviews whether the premium collected justified the risk.
Example
A fund manager owns 10,000 shares and sells calls against them. This is a covered position because she can deliver the shares if called, so she does not face the open-ended risk of a naked call.
Formula
Calculation
Seller's profit on an uncovered call = Premium received - maximum(Share price at expiry - Strike price, 0)
A trader sells one call contract covering 100 shares with a strike price of $50 and receives a premium of $2 a share, so 2 x 100 = $200. At expiry the share price is $58. The option's value to the buyer is (58 - 50) x 100 = $800. The seller's net result is 200 - 800 = -$600, a loss of $600. If the share price had stayed at or below $50, the seller would have kept the full $200.Case study
Seen in the real world.
Silverton Capital is an illustrative, fictional trading firm whose junior trader sold uncovered calls on a technology share for several months. The trader collected steady premiums, and the position appeared very profitable in the monthly report.
When an unexpected announcement caused the share to rise by 40% in a single day, the position lost more than the previous nine months of premiums combined. The risk manager closed it, and the firm absorbed a loss of $1,800,000.
The illustrative lesson is that a strategy that earns small gains most of the time can still carry a large hidden tail risk. Silverton introduced limits on uncovered positions, required daily stress tests and now reports the worst-case loss next to the premium income.
Watch out
Common mistakes.
- Focusing on the premium received while ignoring the size of the possible loss.
- Assuming a stop-loss order will always limit the loss, when a price can jump past the stop level.
- Calling a position covered when the shares or cash held do not match the size of the option.
Questions
People also ask.
Is an uncovered option the same as a naked option?
Yes, the two terms mean the same thing.
Why is an uncovered call riskier than an uncovered put?
A share price can rise without limit, but it can fall only to zero, so the call loss is unlimited while the put loss is capped.
What is margin for?
It is a deposit that protects the broker if the position loses money, and the broker can demand more if the loss grows.
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