A naked option is a financial phrase that refers to an investor who sells an option without maintaining a comparable stake in the underlying securities. Selling naked options is considered a high-risk trading strategy since it exposes the investor to significant risk while yielding a small reward. Nonetheless, since most options expire worthlessly, it is a method many traders use. Selling options may therefore be a successful strategy.
As previously stated, a naked option is the sale of an option without the seller holding a comparable stake in the underlying securities. A covered option, on the other hand, is one that is offered by a seller who does possess a comparable stake in the underlying securities.
Investor A, for example, is considered to be selling a covered option if he already owns 100 or more shares of Stock A and subsequently sells a call option on the stock. Selling a covered put option would need the seller already having a short position in the market by selling 100 or more shares of the underlying company short. The need for 100 shares is due to the fact that conventional stock options are options on 100 shares of the underlying stock.
If the option seller has a market position of fewer than 100 shares, his option selling will be only partly covered. Selling a covered option eliminates the risk of selling the option while limiting the seller's potential profit in the underlying stock to the option's strike price.
The buyer of a call option hopes to benefit from an increase in the price of the underlying securities. A call option gives the buyer the right to acquire a certain quantity of the underlying securities at the option strike price before the option expires. The buyer pays the option seller a fee known as the "premium." The option seller's most significant possible profit from the deal is the premium earned for selling the option.
The buyer of a put option hopes to benefit from a drop in the price of the underlying securities. A put option gives the buyer the right to sell a certain quantity of the underlying securities short at the option strike price before the option expires. The buyer, like the seller of a call option, pays a premium to the seller of the option. The option seller's most significant possible profit from the deal is the premium earned for selling the option.
Naked options are often offered by speculators who are very bullish on the direction of an index or the price of a stock. And, if the market turns against them, they may attempt to rescue the situation by acquiring similar but opposing options. They might also consider having a position in the futures market to offset the losses from selling a naked call or put.
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