Naked means without clothes, uncovered, or unhidden. It can also refer to things that are without their customary covering or enclosure, such as a bare tree.
In options trading, a naked put strategy is when an investor sells puts without holding a short position in the underlying security. This is a risky strategy because it has limited upside profit potential and, in theory, unlimited downside loss potential.
What is a naked put?
Selling naked puts is a risky options strategy. The maximum potential loss incurred when writing a naked put is the strike price of the option, because the investor would be obligated to purchase shares at the strike price if the stock were to go to $0. Selling naked puts requires the option writer to have cash in reserve to cover any possible purchases of the underlying stock should they be assigned the options (margin requirements vary by broker/dealer). This strategy is generally used when an investor expects the price of the underlying stock to rise.
This strategy is similar to that of selling covered calls and should only be undertaken by investors with a high risk tolerance and a good understanding of options trading. It is also possible to combine both strategies, such as selling naked puts until they are exercised and then selling a covered call on the same stock (this is known as a wheel trade). This can help reduce directional exposure and increase premium income.
What is a naked call?
A naked call is an options trading strategy that involves writing (selling) call options in the open market without owning the underlying stock. Also referred to as an uncovered short call or unhedged long call, this strategy offers limited profit potential and unlimited loss potential.
In return for the option premium, the call writer assumes the obligation to buy shares of the underlying asset at the strike price should the buyer exercise the option. Since there is no limit to how high the share price may rise, the risk exposure is unlimited.
Naked calls are considered a high-risk trade and should only be used by experienced traders with a strong grasp of the market and its risks. A covered call is a low-risk variation of this strategy that reduces the potential for unlimited losses. However, even a covered call can suffer significant losses in some cases. This is due to the impact of delta decay, which can cause an option to lose value over time.
What is a naked put option?
Investors who believe the price of an underlying security, typically a stock, will rise may write naked put options. This is a risky strategy because, should the price of the stock fall, the options writer could be forced to buy shares at the strike price. The upside profit potential is limited to the option premium received upon trade entry.
Naked puts require a margin account and the option writer must have sufficient cash in their investment account to cover the purchase of the underlying security if the option is exercised. This differs from a cash-secured put which does not require any funds be set aside as it would be covered by the equity in the options writer’s investment account.
Traders often use this strategy in combination with covered call writing strategies, selling naked puts until the stock is assigned (meaning they are forced to purchase the shares) and then selling covered calls at the same strike. This technique is referred to as a “wheel trade.”
What is a naked call option?
Writing naked call options is a riskier strategy than selling covered calls. The reason is that a seller of naked calls does not have a corresponding position in the underlying shares and, therefore, exposes themselves to unlimited losses on the downside.
For example, imagine that Raymond strongly believes the price of stocks of company X will not exceed $80 per share within six months. He writes a call option for 100 shares with a strike price of 80 and an expiration date of six months. He collects a premium of $5 per share but, in case the price rises, he would have to buy the shares at the market rate and then sell them at the strike price, incurring a loss.
The breakeven point for a naked call is the strike price plus the premium received, which is credited to the investor’s account. To minimize the potential loss, traders with sufficient cash on hand may purchase similar and opposing options or occupy positions in the futures market to offset the negative impact of a large price decline.