A naked option is a type of option trading strategy where the investor sells options without having any position in the security that underlies that option. In contrast to covered options, where the seller holds the underlying securities, naked options are considered risky because they’re associated with unlimited potential losses.
This strategy is typically used when an investor predicts that the price of the underlying security will remain stable or move in a certain direction. For instance, by selling a naked put option, the investor would profit if the price of the underlying security remains stable or increases. However, they would suffer losses if it falls. The amount of loss can be substantial since it’s equivalent to the strike price of the put option minus the current market price of the underlying security, multiplied by the number of options sold.
On the other hand, by selling a naked call option, an investor would profit if the price of the underlying security decreases or remains stable. But if the price of the underlying security rises above the strike price of the call option, the investor would be liable for losses equivalent to the current market price of the security minus the strike price, multiplied by the number of options sold.
Related Questions
1. What is a covered option?
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A covered option is an options strategy where the investor who is selling the options also owns the underlying securities. This strategy is used to generate additional income from the underlying asset or to hedge against potential downside risk.
2. Can naked options be used for hedging?
While naked options are primarily speculative, they can also be used for hedging. For instance, an investor who has short positions in a security can sell naked put options to protect against a rise in the price of the security.
3. What is the risk in selling naked options?
The risk in selling naked options is the potential for unlimited losses. Such losses could occur if the price of the underlying asset moves significantly against the expectation of the investor.
4. Is selling naked options suitable for everyone?
Selling naked options is generally not suitable for beginner or conservative investors due to the high level of risk and complexity involved. Instead, it’s more appropriate for experienced investors with a high-risk tolerance.
5. What’s the minimum requirement for selling naked options?
Brokers typically require investors to have a margin account before they can sell naked options. In addition, they may impose other conditions based on the investor’s level of trading experience and financial resources.