Naked options are a type of option contract — traditionally a stock option — where the option writer does not have offsetting position in the same or related security. Naked options are for experienced investors with knowledge of the stock market; for those investors lacking the expertise to properly manage their risks, investing in naked options can be extremely risky.
No Safety Net With Naked Options
The main reason for the increased risk associated with naked options is the lack of protection for the option writer. Because the option is not hedged, the option writer is exposed to unlimited risk up to the expiration date. If the option does not expire in the money, the option writer is liable for any resulting losses. This risk is not present with hedged options, where any potential losses are restricted by the underlying portfolio.
Naked Options and Relevant Regulations
Although writing uncovered options was once an unregulated practice, many countries now require option writers to obtain approval before writing naked options. Investors can request a grant of permission to write naked options from their brokerage service. However, even with permission to write naked options, the publisher should understand the risks and take more steps to protect the position.
Tips for Managing Naked Options
For investors who choose to enter naked option contracts, there are some steps that can be taken to mitigate the risk. The stock should be closely monitored and the writer should be prepared to exercise the option in order to limit losses if prices move against them. Additionally, there are some strategies that can be employed, such as paired options, to reduce potential losses while still taking advantage of the potential of writing naked options.
Conclusion
For experienced options traders, writing naked options can be a way to capitalize on the market trend. With proper risk management and an understanding of the inherent risks of naked options, investors can take advantage of this strategy in order to benefit from potential gains. However, for those investors with less knowledge and resources, the risks outweigh the potential benefits and these investors should avoid investing in naked option contracts.