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Lesson in Course: Derivatives and options (expert, 7min )
When writing contracts, what does it mean to write naked positions? When should I consider using this strategy?
The concept of a naked position is eyebrow-raising and can be quite suggestive.
In the world of options, a naked position describes an outcome when we write options without having any protection or cover. The goal for writing naked options is to take payment of the premium from the option buyer and hope the option is never exercised. Let's get our minds out of the gutter and explore the pros and cons of this basic strategy.
The three takeaways for this lesson are:
A naked call option is when we sell a call option without owning the underlying.
The advantage of selling a naked call option is that there is no upfront cost for writing the contract.
Put simply, we don't need to own any shares or need to have the money to buy the stock to be able to sell a naked call option.
The disadvantage is that naked calls are very risky and there is no limit on potential losses.
In the profit diagram above, we can see that the maximum profit is capped at the premium we receive for the option. However, if the stock price starts going up and the call option we sold is now in-the-money, there is no limit to the amount of money we can lose.
We can use an example to help us better understand the risks. Let's assume we wrote two naked April 2021 $420 strike call options on $TSLA early November 2020.
For the first half of the month, our short call position was doing quite well until the $TSLA share price shot up towards the end of the month.
As of Dec 8, 2020, we would be on the hook for $129,800 to buy 200 shares since the option holder will definitely exercise the deep in-the-money call option!
We decided to hold on a bit longer in hopes that the stock price would have dropped. As of Jan 8, the stock continued to hit highs and now we owe our brokerage $176,000!
Naked calls expose us to the risk of tremendous loss while only offering limited profit. The risk to reward is not great for naked calls and for that reason they are a bad idea and should be avoided.
A naked put is when we sell a put option without owning or short-selling the underlying stock. Brokerages typically don't allow us to short-sell stocks. So all put options that we sell are naked puts.
The advantage of selling a naked put option is that there is no upfront cost for writing the contract.
Similar to a naked call, the disadvantage is that naked puts can be very risky with limited potential for profit.
One major advantage that a naked put has over a naked call is that underlying prices cannot drop below $0. So there is an eventual cap to the amount we can lose with a naked put. You might be thinking, that this payoff diagram looks a lot like the covered-call payoff diagram. That is because a naked put provides the same outcome as a covered call with the same strike price and premium. While not suggested, naked puts can be used to replace covered calls.
Starting out, we should avoid naked strategies altogether. If we are looking to get paid when the stock price goes up (naked put), we should just buy a call option. If we are looking to get paid when the stock prices go down (naked call), we should just buy a put option. In both cases our losses are limited, and our potential gains are not capped. Being able to recognize naked calls and puts is important for us to avoid them for now. We will learn in future lessons how to combine naked options with other strategies to improve the risk and reward profile.
A naked put is when we sell a put option without also simultaneously short-selling the underlying stock.
When we sell call options without owning the underlying, we are writing naked call options.