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.
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)
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.
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-
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.
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.