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Defining a Naked Option

Updated on May 17, 2024 , 698 views

Covered, naked, puts, calls – undeniably, the world of trading and options comes with a lot of confusing terminologies. However, if you get abreast to all of them, you can easily gain a reward and generate Income seamlessly.

Therefore, to ensure that your confusion and perplexity get to lessen a bit, in this article, you’re going to find brief but profound information regarding naked options. What’s more, you can also explore naked put and naked Call.

Naked Option

So, without further delays, let’s dig into the post and understand this concept so as to generate better income rewards.

What is a Naked Option?

Also known as the uncovered option, a naked option is created when an option contract seller doesn’t possess the Underlying security required to meet the possible Obligation that is resulted from selling (or shorting / writing) an option.

Selling or writing an option creates an obligation of the seller to offer the option buyer with the underlying futures or shares contract for a consistently long position or the cash required for a consistently short position at expiration.

In case the seller doesn’t own the Underlying Asset’s ownership or the cash required to execute a Put Option, he will have to acquire the same at expiration based on the current Market price. With no adequate safety from price Volatility, such a position is regarded as extremely susceptible to loss; thus, known as uncovered or naked.

Understanding Naked Option

As mentioned above, a naked position is a situation wherein a trader sells the option contract without holding any position in the security as safety from a negative shift in the price. These options are generally attractive to investors and traders as they have the anticipated volatility created into the price.

If the Underlying Security goes in the contrasting direction that what the option buyer had expected, or even if it goes in favour of the buyer but not adequate to take care of the volatility, then the option seller gets to keep something from the money premium. Typically, this means that the option seller gets almost 70% of the trade.

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Advantages of Naked Option

Although there is a variety of advantages of using a naked options strategy; however, the biggest one is that your upfront cost is lesser than what would be in a covered strategy. Moreover, you will only be responsible for the margin required to sell a call or a put and not the funding required to possess an underlying share.

Naked Calls

A trader writing the naked Call Option on the stock accepts the obligation to sell the stock for the strike price before or at expiration, irrespective of how high the share price is going to be. In case the trader doesn’t possess the underlying stock, the seller would have to obtain the stock and sell the same to the option buyer so as to gratify the obligation if only the option gets exercised.

The eventual effect is that this will create a short-sell position in the account of option sellers on the next Monday after expiry. In case the seller is selling a put option, the ultimate impact will be to develop a long stock position in the account of the option seller, which is a position bought with cash from the account of the option seller.

For instance, suppose there is a trader who thinks that a specific stock will not increase in value in the next three months; however, he is not confident regarding the decline to be large either. Now, suppose that the stock is priced at Rs. 100 and the strike call is Rs. 105 with the expiry date of 90 dates.

And it is selling at Rs. 4.75 per share. Now, the trader will go with opening a naked call by selling those calls and getting the premium. However, if he doesn’t buy the stock as he thinks the option may expire worthlessly, the trader will retain the entire premium amount.

Naked Puts

Since a naked call seller has unlimited risk; with naked puts, the risk of the seller is contained as the underlying asset, or the stock can only be decreased to zero. A seller of the naked put option has to accept the obligation to purchase the underlying asset at its strike price in case the option gets exercised before or at the expiration date.

Considering that the risk is contained but quite massive; therefore, brokers generally have certain rules linked to naked Options Trading. Also, under these rules, inexperienced and newbie traders may not get the opportunity to place this order type.

All efforts have been made to ensure the information provided here is accurate. However, no guarantees are made regarding correctness of data. Please verify with scheme information document before making any investment.
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