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| Naked Options |
A naked option is an option that is written by the option seller with no underlying asset position in the portfolio to cover its risk exposure. This means that the option seller is purely speculating on the option, assuming a very risky position. Hence, naked options are also called uncovered options, as the seller has no underlying position to cover it.
As the underlying asset starts rising call options follow the move. And, as the underlying asset has no theoretical limit to stop, the liability associated with the short call option position has no theoretical limit too. Therefore, a seller of a call option that has no underlying asset protecting the position has no theoretical loss limit.
The same effect happens for put options, considering deep market falls. When shorting naked puts, investors assume a potential downside risk without any position to sustain the losses. As the market starts falling, the put option position starts incurring losses.
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Selling naked options is a very risky strategy that can be assumed in the options’ market. Sometimes it is difficult to stop losses on naked positions, especially when the series where the seller has a position is far from-the-money (deep in-the-money or deep out-of-the-money).
These series are usually very illiquid and it is sometimes difficult to close out an open positions. In these circumstances, it is advised to “close” the position using a different exercise price, creating a spread position instead.
