The naked call and naked put are option strategies where an investor sells options without having ownership in shares of the underlying stock.
These strategies can be profitable but are very risky and should only be attempted by advanced traders. This article will serve as an introduction to the naked call and naked put.
Naked Call
A naked call is when an investor sells a call option without owning the underlying security. This strategy is used when an investor expects the stock’s price to be trading below the option’s strike price at expiration.
The maximum potential profit from this strategy is the premium collected when the investor sells the call option. This profit is achieved when the option expires worthless.
If a stock’s price rises above the strike price at expiration, then the option seller is obligated to sell the stock at the strike price. In this case, the seller will have to buy the stock at the market price, which is higher than the strike price, then sell the stock at the strike price. Thus, a loss occurs for the option seller.
Since a stock has unlimited upside potential, the potential loss that comes with this strategy is unlimited.
Because the risk associated with a naked call is so high, only investors who are confident that the underlying security’s price will fall or remain flat should execute this strategy.
Let’s look at an example of a naked call.
Assume stock XYZ is trading at $40. An investor executes a naked call by selling a call option with a strike price of $42 that expires in a month. While selling this option, the investor owns no shares of the underlying stock. The seller receives a premium of $2 per share for selling the option.
If XYZ closes at $50 at expiration, then the call option would be exercised. If this happens, the seller of the call option is obligated to sell shares of the stock at $42. Therefore, the seller would buy shares of the stock at the market price of $50, then sell those shares at $42. That is a loss of $8 per share. After accounting for the premium paid to him, the option seller’s total loss becomes $6 per share.
If XYZ closes at $35, then the call option would expire worthless. The seller of the option would not be obligated to sell shares of the stock, and therefore, would not have to buy any shares of the stock. The seller would walk away with a profit of $2 per share from the premium.
Naked Put
A naked put is when an investor sells a put option without holding a short position in the underlying security. This strategy is used when an investor expects the stock’s price to be trading above the option’s strike price at expiration.
This strategy has limited potential profit, and significant potential downside loss. The risk from this strategy heavily outweighs the potential rewards associated with it.
The maximum profit comes from the premium received by the seller of the option. This profit can only be achieved if the underlying price expires above the strike price, thus making the option expire worthless.
If a stock’s price falls below the strike price at expiration, then the option seller is obligated to buy the stock at the strike price. In this case, the seller will buy the stock at the strike price, which is higher than the market price. Thus, a loss occurs for the option seller. The investor’s potential loss from this strategy increases as the underlying stock’s price falls to zero.
Because the risk associated with this strategy is so high, only investors who are confident that the underlying stock’s price will rise or stay the same should execute naked puts.
Let’s look at an example of a naked put.
Assume stock XYZ is trading at $40. An investor executes a naked put by selling a put option with a strike price of $38 that expires in a month. While selling this option, the investor owns no shares of the underlying stock. The investor receives a premium of $2 per share for selling the option.
If XYZ closes at $35 at expiration, then the put option would be exercised. If this happens, the seller of the put option is obligated to buy shares of the stock at $38. Therefore, the seller would buy shares of the stock at the market price of $38, rather than the market price of $35. That is a loss of $3 per share. After accounting for the premium paid to him, the seller’s total loss becomes $1 per share.
If XYZ closes at $45, then the put option would expire worthless. The seller of the option would not be obligated to buy any shares of the stock. The seller would walk away with the premium paid to him as his maximum profit of $2 per share.
Closing
The naked call and naked put are both effective strategies that can generate a profit for an investor. However, it should be known that these strategies have a limited potential profit and an unlimited potential loss. Thus, the naked call and naked put should only be executed with caution and confidence.
