What is Uncovered or Naked Options Trading?

Short Answer

Naked or Uncovered Option trading is a type of trading/speculating where a Call or Put option is bought or sold by different individuals at the same time expecting different price direction movements. Naked Option trading is a Zero-Sum game which means that the Profit for one is a Loss for the other individual.

Detailed Answer

Naked or Uncovered options trading is a way of speculating in the derivatives space where a trader or investor buys or writes (Sells) an option in order to benefit from the price change of the Option Price.

Trading naked options are pure speculating activity as it does not involve any hedge against the position taken by the trader. In an uncovered option trade (Buying or Selling) there is an obligation to take or give delivery of the underlying asset (stock) on the date of expiry.

If a seller of a Call option holds on to his position till the date of expiry then he is obligated to give the delivery of the underlying asset to the Option buyer. In this same way, the Buyer of a Call option will have to pay the entire amount of the underlying security and take delivery of the Security.

There are 2 aspects of Naked or Uncovered Option Strategies, they are-

1. Option Buying

2. Option Writing(Selling)

1. Option Buying-

In Option buying the trader buys an Option by paying a small price for it known as the Premium expecting the price of the underlying asset to rise or fall to that specific Strike Price before the expiry in order to earn money. Option buying can be compared to buying a lottery ticket as the chances of winning big is there but are very small. For example, the buyer of a call Option will start to make money when the price of the Underlying Stock/Index will go above his Strike Price before the expiry.

The chances of making money in Option Buying are quite less as Option Greeks such as Delta, Gama (Option Decay) are against Option buyers. The advantage in option buying is that the loss is limited to the Total Premium paid while purchasing the option and the maximum profit is limitless.

2. Option Writing-

Opting writing or Option selling is comparatively more profitable than Option Buying as the Option Greeks work in favor of the option writer to reduce the price of the option. Option Selling is also treated as a steady business because the Return On Investment (ROI) is reasonable and if done right can provide steady profits for option writers. In Option Selling the Seller sells an Option and Collects the Premium at the time of execution and buys it at a lower price at a later time to earn Profit.

Let's see how Naked Options Trading works-

1. Naked Call Options-

In a Naked Call option strategy, the Buyer of the Call option Buys the Option by paying a premium of 'X' amount, and the same 'X' amount is collected by the Writer (seller) of that particular Option. Now if the price of the Underlying security rises then the Premium of the Call Option will rise hence the Buyer of that Option will make money and simultaneously the Seller will face some MTM (Mark To Market) losses till the time he holds on to the position.

2.Naked Put options-

A naked Put Option is bought by the Option buyer anticipating that the price of the underlying security will fall and the Seller of the Put option sells that same Put option anticipating that the price of the particular asset will rise. Now if the Price of the underlying security starts to rise then the Price of the Put Option will fall resulting in a loss for the option buyer and an MTM profit for the Option seller.

In the following ways, Naked Options are bought and sold in order to earn money from the price movement of the underlying asset. Buying Naked options is extremely risky as the value of the option becomes worthless on the day of expiry if the price is away from the particular Strike Price.

On the other hand, Option sellers face the risk of unlimited losses, but the chances of making profits consistently in Option writing is more than Option Buying. Trading in Naked or Uncovered Option is very risky hence it is always a good idea to hedge the Naked positions to minimize the losses and maximize the gains.

Tagged With: uncovered options tradingnaked options tradingcall optionput option
Categories: Option Trading
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Related FAQs

What is Call Option and Put Option?

Options are a form of conditional derivatives policy that allows the holder to buy or sell the key asset at a fixed price before or after the agreement expires. The two most impactful options are Call Options and Put Options.

Why is Options Trading considered risky?

Options trading is different from traditional share trading in many ways. Trading in options includes multiple factors like high leverage, delivery obligation on the date of expiry, unlimited loss potential, etc. All these factors make trading in options riskier.

How much money is required for Options trading?

Options trading involves two aspects. One is options buying and the other is options selling. To buy an ATM option you will require around Rs 10,000 to Rs 25,000 per lot for an Index or stock option. On the other hand, you will require close to Rs 95,000 to Rs 1,50,000 for selling 1 lot of index option. These amounts change with respect to the time remaining to expiry and other market conditions.

Can I trade in US Options from India?

Yes, individuals can trade US options from India. There are many platforms as well which allows the individuals to trade internationally, it just depends on them what they are comfortable the most with and prefer trading from.

Why is Options Trading more risky on the expiry day?

Options trading involves many factors such as Options Greeks. Options Greeks like Delta, Theta, and Gamma have the most impact on Option prices towards the end of the expiry. The option premiums are impacted highly by Gamma and Delta on the day of expiry. Learn more about Options greeks and how they impact option premiums.

Are puts riskier than calls? Risks to Consider

Puts are Calls are both risky in their own terms. For calls it is necessary to make decisions well as there are chances that you make loose the premium. In case of puts it is important to strategize the the options well.

What is an Iron Condor trade in options?

An Iron Condor is a 4 legged hedged option strategy that includes selling 1 slightly OTM (Out of The Money) Call as well as 1 Put option and, buying 1 Slightly Far OTM Put & 1 Call options in order to cover the risk of the Naked short positions. This strategy is implemented when the overall outlook of the underlying asset is neutral or rangebound and no major moves in any direction are anticipated. The maximum profit and loss are capped in this strategy, and by hedging, margin benefits can be enjoyed.

Which Options Greeks should you know about before Trading Options?

Options Premiums are primarily made up of two values. Intrinsic Value and Time Value. Whereas the change in the price of the Option premiums is dependent on five factors called Option Greeks. These are Delta, Gamma, Theta, Vega, and Rho. Know more about options greeks and which Greeks should a trader keep an eye on while trading Options.

What is the minimum amount required for Options Trading in India?

Options are of two types- call option and put option. You need quite an amount of money to trade in options because it has costs such as premium, brokerage. etc. To know more about the topic, read the detailed version.

What can high open interest rate indicate about options?

Open Interest or OI is a parameter to measure the number of Outstanding contracts (Not Squared off) at a particular strike price. The near strike prices to the Spot has higher Open interest compares to OTM (Out of The Money) contracts. Higher OI has many benefits like High liquidity and low spreads and some disadvantages.