What is a Naked Option?
Naked option refers to an option contract which does not comprise ownership of the underlying security by the purchasing or selling party. It is the opposite of a covered option.
How Does a Naked Option Work?
Also called an uncovered option, a naked option is a put or call option for which the selling or buying party does not own the units of the associated underlying security. In the case of a naked put option, the purchasing party does not own the underlying units; and in the case of a naked call option, the selling (writing) party does not own the underlying units.
To illustrate, if an investor writes a naked call option involving 100 units of stock XYZ, the writer does not actually hold the 100 XYZ units. Likewise, if those same 100 shares are involved in a put option, the purchasing party does not own them.
Why Does a Naked Option Matter?
Naked options provide options investors with the opportunity to profit from the respective premiums without having to enter into an actual long or short position. In the event that the market price of the underlying security renders a contract out of the money (OTM), the losses are virtually unlimited.