What is the Uncovered or Naked Options Strategy?

Options are the most popular way to trade stocks or commodities. It allows you to trade only when the market is favourable for a small premium. Among many options strategies, one is uncovered options. 

What are the Uncovered Options?

It is a derivative strategy in which you have no opposite position in the underlying asset, neither in the F&O market nor in the cash market, to offset the loss if the price moves against you. Uncovered options are often selling contracts in which you intend to write off the underlying asset at a predetermined price on a future date. Given its features, it is commonly known as “naked options selling.”

Naked options are traded to profit from speculative market views rather than to hedge your portfolio’s risk.

What are the different types of Naked Options?

1. Naked Call Options

In this uncovered option, you seek to profit from an increase in the underlying asset’s price. The naked call gives you the right to buy the underlying asset in a specific quantity at a predetermined price on a pre-decided date by paying the premium to the naked call seller.

Example– 

Suppose HCL shares are trading at Rs 1,030. Your friend sells a call option with a strike price of Rs 1100 to you. 

Scenario 1

HCL’s share price trades below Rs 1100 on the expiry. If you do not exercise the buying option, you will lose the premium you pay to buy the call options

Scenario 2

HCL’s share price trades above Rs 1100 on the expiry date. You can profit by selling the contract to another person or exercising the options as per the agreed-upon terms.

2. Naked Put

In this uncovered option, you seek to profit from a fall in the underlying asset’s value. The naked put gives you the right to sell the underlying asset in a specific quantity at a predetermined price on a pre-decided date. 

Example– 

Scenario 1

In the case of HCL, if the share price trades above 1100 on expiry and your friend does not exercise the buying right, your profit will be the premium collected on the put options for taking the sell position. Whereas; your friend will lose the premium he paid to go long on the contract.

Scenario 2

HCL’s share price falls below the strike price, and your friend exercises his option. Here, your loss will be the difference between the strike price and the price on the expiry date multiplied by the number of shares in the lot, less the premium collected.

What are the benefits of Naked Options?

  • Liquidity: Naked trading creates no barriers to entry or exit from the market, making it not only liquid in a favourable trade position but secure.
  • Cost-effective: You will need a small amount of capital to trade naked options. The margin requirement is only 3-4% of the underlying asset if the contract is at the money (ATM).

What are the drawbacks of Naked Options? 

  • Directional risk: Since you have no converse position in the underlying assets, you will lose money if the price moves in the opposite direction of your speculation.
  • Brokerage issues: Brokers may seek to profit from the gap if the loss on the naked positions continues to rise. As a result, they may compel you to exit your profitable position.

Final Words

Naked buying options, put or call, have an unlimited profit potential with a loss limit of the premium. However, when it comes to naked options selling, the profit potential is limited to the premium received, but with no capping on the loss.