Naked Option
A naked option arises when the seller of an option does not possess the underlying security required to meet the obligation of the option contract. This situation involves significant risk due to the potential for abrupt price changes affecting the security.
Definition and Risk
Naked options are sold without the seller holding the necessary shares or cash to cover the contract at its conclusion. Such options carry a high risk of loss from sudden market moves. Naked calls lead to a short position, while naked puts result in a long position in the seller's account.
Operational Dynamics
Uncovered or naked options mean the seller has sold the option without backing. This strategy banks on the volatility priced into the option, favoring the seller if the market does not move as expected or insufficiently to overcome the priced-in volatility. Historically, this results in the seller profiting in a significant majority of trades.
Implications for Sellers
Selling naked options obliges the seller to either deliver the underlying shares for a call option or arrange the cash for a put option by expiration. Without the asset or cash, the seller must acquire them at current market prices, exposing them to high risk due to market volatility.