Legal Definitions - naked option

A naked option, also known as an "uncovered option," is a type of option contract where the seller does not actually own any, or enough, of the underlying stock. This means that when the buyer exercises the option, the seller must purchase the shares and sell them under the terms of the option contract.

There are two types of naked options:

• Naked call option: This is when the seller makes a short position in their account.
• Naked put option: This is when the seller makes a long position in their account, purchased with available cash.

Traders and investors prefer naked options because the predicted volatility is already factored into the price. However, there is a risk of large loss if the price changes dramatically before expiration.

Let's say that John sells a naked call option to Jane for 100 shares of XYZ stock at a strike price of $50 per share. John does not actually own any shares of XYZ stock. If the price of XYZ stock goes up to $60 per share and Jane exercises the option, John will have to purchase 100 shares of XYZ stock at the market price of $60 per share and sell them to Jane for $50 per share, resulting in a loss of $1,000.

This example illustrates the risk of selling a naked option without owning the underlying stock. If the price of the stock moves against the seller, they can face significant losses.