What Are Uncovered Options?
Uncovered options refer to an option contract where the seller, also known as the option writer, does not own the underlying asset that the option represents. These are also frequently called "naked options.", This strategy falls under the broader financial category of options trading, a segment of derivatives. When an investor sells an uncovered option, they collect a premium from the option buyer but take on a potentially unlimited risk, especially with uncovered call options, because they would have to acquire the underlying asset at market price if the option is exercised, regardless of how high that price might rise.,20
History and Origin
The concept of options trading has ancient roots, with early forms believed to exist in Ancient Greece. However, the modern, standardized options market began with the establishment of the Chicago Board Options Exchange (CBOE) in 1973.19, Before this, options were primarily traded over-the-counter (OTC) with less standardization and transparency. The CBOE's creation brought organized, listed options to the forefront, standardizing option contract terms such as strike price and expiration date.18,17 This standardization, along with the development of pricing models, helped to legitimize options trading and paved the way for more complex strategies, including the writing of uncovered options. The CBOE was founded by the Chicago Board of Trade in 1973, aiming to bring options trading to more people and improve the previously manual, phone-driven processes.,16
Key Takeaways
- Uncovered options involve selling an option contract without owning the underlying asset.
- This strategy offers limited profit potential (the collected premium) but carries a risk of potentially unlimited losses for the seller.
- Uncovered options require a margin account with sufficient capital to cover potential obligations.
- They are considered a high-risk, speculative strategy and are generally restricted to experienced traders.15
Interpreting Uncovered Options
Understanding uncovered options requires a clear grasp of the risk an option seller undertakes. When an investor sells an uncovered call option, they are betting that the price of the underlying asset will not rise above the strike price before the option's expiration date. If it does, the seller is obligated to sell shares they do not own at the lower strike price, potentially having to buy them in the open market at a much higher price. Similarly, selling an uncovered put option implies a belief that the underlying asset's price will not fall below the strike price. If it does, the seller is obligated to buy shares at the higher strike price, even if the market value is significantly lower. The profit for the seller is limited to the premium received, while losses can theoretically be substantial.
Hypothetical Example
Consider an investor who believes that XYZ stock, currently trading at $100 per share, will either remain flat or decrease slightly. To profit from this outlook, the investor sells (writes) an uncovered call option with a strike price of $105 and an expiration date one month away, collecting a premium of $2.00 per share (or $200 per standard 100-share contract). The investor does not own any shares of XYZ stock.
- Scenario 1: XYZ stock closes at $104 at expiration. The option expires worthless, as the price is below the $105 strike. The investor keeps the $200 premium as profit.
- Scenario 2: XYZ stock closes at $107 at expiration. The option is "in the money" and the buyer will likely exercise it. The investor is obligated to sell 100 shares of XYZ at $105. Since they do not own the shares, they must buy them on the open market at $107 per share.
- Cost to buy shares: $107 x 100 = $10,700
- Proceeds from selling shares (due to option exercise): $105 x 100 = $10,500
- Initial premium received: $200
- Net Loss = ($10,700 Cost) - ($10,500 Proceeds) - ($200 Premium) = -$400.
This example illustrates the significant loss potential when the market moves against the option seller's expectation.
Practical Applications
Uncovered options are primarily used by sophisticated investors for speculative purposes, aiming to generate income from the collected premium. For instance, an option seller might write uncovered put options on a stock they wish to acquire at a lower price, hoping the option will be exercised if the stock falls. Conversely, writing uncovered call options can be a strategy to profit from anticipated stagnation or decline in an underlying asset. This involves a high degree of conviction in market direction and an acceptance of substantial risk management challenges. The volume of options traded globally, as reflected in market statistics from exchanges like Cboe Global Markets, demonstrates the widespread use of various options strategies, including those involving uncovered positions, by market participants.14,13,12 Recent market activity, particularly amplified volatility, has influenced trading volumes as investors and portfolio managers have sought to manage risk, sometimes through derivative products.11
Limitations and Criticisms
The primary limitation and criticism of uncovered options is the potential for unlimited loss.,10 When writing an uncovered call option, if the underlying asset's price rises significantly, the seller faces an obligation to deliver shares they do not own, which could lead to losses far exceeding the initial premium received. For uncovered put options, losses can occur if the underlying asset's price falls towards zero. Due to this elevated risk, brokerage firms typically impose stringent requirements, including substantial margin account balances, for clients wishing to engage in such strategies.
Regulatory bodies, such as the Financial Industry Regulatory Authority (FINRA), provide extensive disclosures on the "Characteristics and Risks of Standardized Options" to educate investors on these dangers.9,8,7 The speculative nature of uncovered options, especially among retail investors, has drawn scrutiny, with some reports highlighting the high stakes involved.6,5,4 Investors engaging in these strategies must possess robust risk management practices and a thorough understanding of market dynamics. This type of options trading is generally not recommended for inexperienced traders due to its complexity and inherent risk.3
Uncovered Options vs. Covered Call
The key distinction between uncovered options and a covered call lies in the ownership of the underlying asset.
- Uncovered Options: In this strategy, the option seller writes a call option (or a put option) without owning the corresponding shares of the underlying asset. This exposes the seller to unlimited risk with calls and substantial risk with puts, as they would have to acquire the asset at an unfavorable price if the option is exercised. The profit is capped at the premium received.,
- Covered Call: This is a more conservative strategy where the investor sells a call option against shares of the underlying asset they already own. The ownership of the shares "covers" the obligation to deliver them if the option is exercised. While it caps potential upside profits on the stock, it also limits the risk to the downside (stock price decline) by the amount of the premium received, making it a common hedging or income-generating strategy.
The confusion often arises because both involve selling an option contract to receive a premium. However, the presence or absence of the underlying stock fundamentally alters the risk profile, with uncovered options (or naked options) being significantly riskier.
FAQs
What is a naked call option?
A naked call option is another term for an uncovered call option. It refers to a strategy where an investor sells a call option on an underlying asset without actually owning the asset. The seller hopes the price will not rise above the strike price, allowing the option to expire worthless, and they keep the premium received. If the price rises significantly, the potential losses are theoretically unlimited.,2
Why are uncovered options considered so risky?
Uncovered options are highly risky because the potential for loss is not capped. For an uncovered call, if the price of the underlying asset rises indefinitely, the option seller could be forced to buy the asset at a very high market price to fulfill their obligation to sell it at the lower strike price. This open-ended risk means losses can far exceed the initial premium collected.
Can retail investors trade uncovered options?
Yes, but typically with significant restrictions. Most brokerage firms require investors to have a high level of options trading approval and a substantial margin account to trade uncovered options. This is due to the elevated risk management complexities and the potential for large losses associated with these derivative positions.,1
What is the maximum profit on an uncovered option?
The maximum profit an option seller can realize from an uncovered option is limited to the premium received from the option buyer when the contract is initially sold. If the option expires worthless (out of the money), the seller retains the entire premium.
How do uncovered puts differ from uncovered calls in terms of risk?
While both are uncovered strategies, the risk profile differs. An uncovered call option has theoretically unlimited upside risk because a stock's price can rise infinitely. An uncovered put option has substantial but not unlimited downside risk, as a stock's price can only fall to zero. In both cases, the risk can be significant if the market moves unfavorably against the option seller.