What are Naked Options?

In the world of derivatives, you must have frequently come across terms like naked options, covered options, closed options, etc. Our focus will be on naked options here, but we will quickly understand what is a covered option and a closed option before we go into understanding what are naked options. Let us say you are holding 5,000 shares of SBI and want to protect against the price falling. You can buy an SBI put option. Here your put option is not a trading position but just to protect your stock holding in SBI. It is therefore a covered option.

Then some options are not backed by positions but the risks are limited. Typically, buy options have limited risk but sell options have unlimited risks. A bull call spread where you buy a lower call and sell a higher call is a classic example of a closed options position because the loss is limited and even profits are defined. The opposite of these is naked options, where you trade in options purely to make a profit. So, you buy options expecting premium to go up or sell options expecting premium to go down. These are examples of naked options.

Naked Options

Let us first understand what are naked options 101. Just to illustrate, when you hold naked options, you hold an option without holding the underlying security or the commodity. As we said earlier, in naked options, the intent is not to protect your underlying position but just to make speculative profits from expected movement in prices of options. Remember that in India most of the options are cash-settled in the commodity markets and all options on the equity market and currency market are necessarily cash-settled only. That means; these options can be traded as naked options since you don’t need any underlying to take delivery. Naked options are speculative with the sole intent to make profits. At times even investors use naked options as a proxy for equity investing.

There is a small distinction you must remember here. When you buy a naked option, it is ok as your risk is still limited to the option premium paid. That acts as protection. However, when you sell a call or put option, it is a more dangerous form of naked options. In such naked options, the losses can be just unlimited making them very risky if appropriate risk management measures are not adopted. For example, if you sell a put option without owning the underlying stock, you have what’s called a naked put position with a very high degree of risk implicit in the position. In the world of derivatives, you can either be a naked options seller or a naked options buyer, or you can even be both.

A quick look at the advantages of naked options

While naked options are prima facie risky, some unique advantages make these naked options quite popular.

• It allows speculators to enter and exit the trade for a profit and in the process, they do create liquidity in the market and make trading more secure. Naked options trading has no entry barriers.
• Quite often, even though buying naked options may appear speculative, the argument is that the loss is limited to the option premium paid. When people are willing to take a small speculative risk for large gains, naked options offer a good choice.
• The capital requirement is much lower. For example, the cost of buying an option that is ATM or slightly OTM would not be more than 3-4% of the notional value. Hence it allows traders to take bigger positions using naked options with smaller capital at their disposal.
• Unlike in the cash market or even in the futures market, the biggest perk of naked options is that the upfront costs are lower than they would be if you were to use a covered strategy or to apply a similar strategy in cash or futures.
• Even if you were to sell options with the downside risk, you only pay the margins to trade and you can protect your losses with the use of strict stop losses and profit targets. Many traders do not see trading in naked options as anything riskier than trading intraday in equities, despite the leverage risk.
• Last but not the least, naked options are a form of leverage without interest. You can take a larger position using naked options without going through the hassles of borrowing money and paying interest and adding to your costs. That makes naked options a lot more economical.

  However, despite the merits of naked options, there are risks that one must not and should not overlook. Firstly, and foremost, when you sell naked options, you face directional market risk. Things can snowball if the price moves against you. Secondly, MTM margins are a big risk and you can have a problem if you are not prepared for it. Thirdly, when losses mount on naked positions, many brokers force you to liquidate profitable positions to make good the gap.

What are naked put and call?

A naked put or naked call is an options position you have taken speculatively without any underlying asset risk that you run. These speculative naked positions are pure with the intent of making profits and not to protect against any uncertainty in the market. Calls are a right to buy without an obligation to buy while puts are a right to sell without the obligation to sell. You can either be a naked buyer of a call, naked seller of a call, the naked buyer of a put, or naked seller of a put.

What are the covered options?

Covered options are those that are covered or supported by underlying positions. For example, you have bought SBI and the price has gone down recently. Now you decided to sell higher call options of SBI so that you keep collecting the premium and reducing the cost of holding SBI. In this case, the position is covered. You are holding SBI in cash so you don’t worry about the price going down. When the price goes down, you make the full premium on the call options sold. In a worst-case scenario, if the stock price of SBI shoots up, you have a risk of the call option you have sold. But, relax, you are holding SBI so you are safe.