What it is:
Naked position refers to any securities holding which has not been hedged for risk by any accompanying options or futures contracts.
How it works (Example):
A naked position in a given security is exposed entirely to fluctuations in its market price. The position does not have any offsetting put options contracts to absorb losses due to price declines. In other words, a naked position experiences proportionally large gains resulting from an exceptional rise in price accompanied by similar losses in the event that the price goes down. For instance, a position of 100 shares of XYZ stock is considered a naked position because a per share price increase of $10 represents a $1,000 gain, a $10 per share price decline represents a $1,000 loss.
Why it Matters:
Market price fluctuations affect gains and losses associated with invested position. For this reason, investors with large holdings of a single stock are advised to hedge against risk. One way to hedge is to purchase put options on a stock, which gives investors the right to sell a stock at a specific price known as the strike price. If your stock tumbles below the strike price, investors can offset some of the losses with the gains from the put option.