Naked Option: Overview, Types, Example, Trading Strategies
Naked options trading refers to the practice of selling or writing options without holding the underlying asset or a corresponding hedge. Naked option is a high-risk, high-reward strategy is popular among experienced traders due to its potential to generate profits through the options premium, which serves as the seller’s maximum profit.
Naked options include two types: naked calls, where the seller anticipates the price will not rise above the strike price, and naked puts, where the seller expects prices to stay above the strike price.
As part of advanced options selling strategies, naked options are speculative and require precise market predictions. While they offer flexibility and leverage, their unlimited loss potential for naked calls and substantial risk for naked puts make them highly volatile.
What is a Naked Option?
Naked options are option contracts sold by a trader without holding the underlying asset or sufficient funds to cover potential obligations. Naked options expose the seller to significant risk, as they lack protection against adverse price movements, which sometimes lead to unlimited losses in the case of naked calls or substantial losses for naked puts.
Despite the high risk, traders are attracted to naked options for their speculative potential and the premium income they generate. This strategy is generally reserved for experienced investors with a high tolerance for risk.
What’s the Difference between Naked vs Covered Option?
The primary difference between naked options and covered options lies in the seller’s position regarding the underlying asset. A naked option, also called an uncovered option, is when the seller writes an option contract without owning the underlying asset or holding a corresponding position to cover potential obligations.
This exposes the seller to unlimited risk, as they must fulfill the contract regardless of adverse price movements. In contrast, a covered option involves the seller owning the underlying asset (e.g., shares for a call option), which acts as a hedge to limit potential losses.
The term “uncovered” is used for naked options because the seller does not have any protective position or asset to offset potential losses, making it a speculative and high-risk strategy. Covered options, on the other hand, are considered safer due to the ownership of the underlying asset
What are The Types of Naked Options?
The two types of naked option sare naked call option and naked put option. Below are more details.
1. Naked Call Option
A naked call option involves trading call options without owning the underlying asset, exposing traders to substantial risks. This strategy is divided into two types – naked long call and naked short call.
In a naked long call, the trader purchases a call option without holding the underlying asset. By paying a premium, the buyer gains the right (but not the obligation) to buy the underlying asset at a specified strike price before expiration.
This strategy is typically used when the trader expects a significant upward movement in the asset’s price. The potential profit is theoretically unlimited if the price rises substantially above the strike price, while the maximum loss is limited to the premium paid.
Above pic is payoff of long ITM call of nifty, CMP of nifty spot is 24200.
In contrast, a naked short call involves selling a call option without owning the underlying asset. The seller receives an upfront premium but assumes unlimited risk if the underlying asset’s price rises significantly above the strike price. This strategy is used when the seller expects little to no upward movement in the asset’s price.
This pic is of short ATM call in nifty, CMP of nifty spot is 24200.
While naked long calls have defined risks and unlimited profit potential, naked short calls carry unlimited risks and limited profits, making them suitable only for experienced traders with high-risk tolerance
2. Naked Put Option
A naked put option involves trading put options without holding a corresponding short position in the underlying asset. This strategy is divided into two types – naked long put and naked short put.
In a naked long put, the trader purchases a put option without owning the underlying asset. By paying a premium, the buyer gains the right (but not the obligation) to sell the underlying asset at a specified strike price before expiration. This strategy is used when the trader expects a significant decline in the asset’s price. The maximum profit occurs if the asset’s price falls to zero, which equals the strike price minus the premium paid.
This is a long ITM Put in Nifty. CMP of nifty spot is 24200.
Naked short put involves selling a put option without holding cash or assets to cover potential obligations. The seller receives an upfront premium but assumes substantial risk if the asset’s price falls below the strike price.
This strategy is profitable if the stock price stays above or at the strike price, as the option expires worthless and the seller keeps the premium. However, losses are sometimes substantial, though not unlimited (as prices cannot fall below zero). For instance,
Naked long puts have limited risks and high profit potential in bearish markets, naked short puts carry high risks and are suitable only for experienced traders with adequate margin reserves.
Why Trade Naked Options?
There are five main reasons to trade naked options. Below are them.
- High Premium Income: Naked options allow traders to collect premium income upfront, making them attractive for those pursuing speculative income strategies. The premium serves as the primary source of profit if the option expires worthless.
- Market Volatility Profits: Traders benefit from sideways or stable markets, as naked options often expire worthless in such conditions. This strategy also leverages time decay (theta), which works in favor of the seller.
- Leverage and Margin Benefits: Naked options offer significant leverage, enabling traders to control large positions with relatively low initial capital. This makes them a cost-effective way to speculate on price movements.
- Flexibility: By selling naked calls or puts, traders express a variety of market views, such as bearish, bullish, or neutral outlooks, without owning the underlying asset.
- Short-Term Opportunities: Naked options are often used for short-term trades to capitalize on quick market movements or time decay.
While these benefits are appealing, naked options come with substantial risks, including unlimited loss potential for naked calls and high margin requirements, making them suitable only for experienced investors.
Example of Trading Naked Option
Below is an example of trading naked options using a Nifty chart.
In this example, a 23700 strike call option has been purchased nakedly while Nifty is trading at 23,750. The option was bought for ₹245 per lot, meaning the trader has invested ₹50,000 in total.
For this trade to break even, Nifty must rise above 23,950 (200 points higher than CMP) by expiry. If it stays below this level, the position will remain at a loss. The worst-case scenario? If Nifty remains flat or declines, the entire premium amount—₹50,000—could be wiped out due to complete premium erosion. This is the biggest drawback of naked call buying.
However, the upside of this strategy is its theoretically unlimited profit potential. If Nifty moves significantly higher, gains can be exponential. Additionally, skilled traders who excel at scalping small price movements can generate consistent profits—provided they manage risk meticulously.
While naked call buying offers high reward potential, it demands precision, discipline, and strict risk management to avoid heavy losses.
Example of Naked Call Trading
Let us look at an example of naked call trading. The underlying asset selected for this trade is the Nifty 50 index, with the nearest monthly expiry in four days.
The option seller is operating under the assumption that, despite the current bearish trend, the market is likely to continue falling or remain stagnant for a few days. A strong resistance level at 23,200 has been identified, leading the trader to believe that Nifty will close below this level by expiry.
Based on this conviction, the trader aims to maximize premium collection from the call side by selling a 23,250 call option for ₹45 without any hedge. This position remains profitable as long as Nifty stays below 23,250.
While the trader is comfortable with a bearish outlook, they recognize that the market may consolidate before expiry. To take advantage of this potential sideways movement, a put option at 22,450 is also sold for ₹40. However, since the trader is unsure about the support level, they hedge the downside risk by buying a 22,350 put option for ₹30.
This ensures that if Nifty experiences a sharp decline, losses from the short put are capped, thereby minimizing risk on the downside. The strategy, therefore, balances conviction in a bearish move while incorporating hedging to protect against excessive losses.
At expiry, if the trade plays out as expected, the total premium collected will be ₹45 from the call side and ₹10 from the hedged put position (₹40 from the short put minus ₹30 for the hedge). This setup allows the trader to profit from time decay and market stagnation, provided Nifty remains within the anticipated range.
The payoff diagram of this position clearly illustrates how the downside risk is minimized through a carefully placed hedge on the short put contract. However, it also highlights a key risk factor—the call side remains unhedged, meaning that if Nifty moves unexpectedly above 23,250, the losses can be theoretically unlimited.
For maximum profit, Nifty must close below 23,250. The breakeven point is at 23,305, meaning that if Nifty closes anywhere between 23,250 and 23,305, the position will neither profit nor lose. If it surpasses this level, the trade will start incurring losses, requiring active risk management strategies to contain potential damage.
Example of Naked Put Trading
Let us look at an example of naked put trading using Nifty 50 charts.
In this scenario, Nifty 50 is expected to decline, presenting an opportunity for traders to profit from a downward move. The trader has opted to buy a naked At-The-Money (ATM) put option to capitalize on the expected fall. The payoff diagram clearly illustrates the risk-reward profile, where the flat red line represents a limited loss potential, capped at 100% of the premium paid.
Currently, Nifty 50 is trading at ₹23,750, and the trader has invested ₹50,000 in purchasing a 23,800 strike put option at ₹175. For this position to break even, Nifty must drop below ₹23,650 before expiry. If the index fails to decline or remains flat, the position will remain slightly negative until it reaches breakeven.
However, if Nifty does not fall below ₹23,650, the trader risks losing the entire investment due to 100% premium erosion—a major drawback of option buying.
For this naked put position to turn profitable, Nifty 50 must fall below ₹23,650 by expiry. The lower it goes, the higher the potential profit, as put options gain value in a falling market. Conversely, if Nifty remains bullish or stagnant, the entire premium paid can be lost, making naked put buying a high-risk strategy. This highlights the primary disadvantage of option buying—time decay and premium erosion if the anticipated move does not materialize.
What are the Top Naked Option Trading Strategies?
Below are the top naked option trading strategies explained in detail.
1. Premium Collection Strategy
The premium collection strategy is one of the most popular uses of naked options. It involves selling naked call or put options to generate immediate income from the premiums paid by buyers. The seller profits if the option expires worthless, which occurs when the underlying asset remains below the strike price for a naked call or above the strike price for a naked put.
The primary appeal of this strategy lies in its ability to generate consistent income, especially in stable or range-bound markets. For instance, a trader sells a naked call option on a stock priced at ₹100 with a strike price of ₹110 for a ₹5 premium, then they will keep the ₹5 premium as profit if the stock remains below ₹110 by expiration. Similarly, selling a naked put on the same stock at a ₹90 strike price would yield profits if the stock stays above ₹90.
However, this strategy is not without risks. Naked calls carry theoretically unlimited loss potential if the stock price surges significantly beyond the strike price. Naked puts, while limited in loss potential (since a stock’s price cannot fall below zero), still lead to substantial financial losses if the stock price drops sharply. Due to these risks, traders must carefully monitor their positions and ensure they meet margin requirements to avoid forced liquidations.
This strategy is ideal for traders pursuing income strategies, as it provides upfront cash flow and benefits from time decay (theta), which erodes an option’s value as expiration approaches.
2. Volatility Trading Strategy
The volatility trading strategy leverages changes in market volatility to profit from movements in option prices. Naked options are particularly sensitive to implied volatility, making them effective tools for traders who anticipate market swings.
In low-volatility environments, traders often sell naked options (calls or puts) with the expectation that volatility will remain subdued. If volatility stays low and the underlying asset does not breach the strike price, the options expire worthless, and the seller keeps the premium as profit. Conversely, during periods of high implied volatility, traders may purchase naked options to capitalize on large price swings in either direction.
Duuring high volatility, buying a naked call on an asset expected to rise sharply could yield significant gains if the asset’s price surges beyond the strike price plus the premium paid.
While this strategy is lucrative, it requires precise timing and an accurate forecast of market conditions. A sudden spike in volatility sometimes lead to significant losses for sellers of naked options, while buyers risk losing their entire premium if volatility does not materialize as expected.
This approach is best suited for experienced traders who understand how implied volatility impacts option pricing and actively manage their positions.
3. Hedging with Other Positions
Naked options are also used strategically as part of broader hedging techniques to offset risks in other investments. This approach transforms naked options into tools for risk management rather than pure speculation.
For example, selling a naked call act as a hedge against potential losses in long equity positions if prices remain flat or decline slightly. Conversely, selling a naked put hedge against short equity positions by providing income that offsets small upward movements in stock prices.
Consider a trader holding shares of a stock priced at ₹150 but expecting short-term stagnation or minor declines. To hedge against potential losses while generating additional income, they could sell a naked call option with a strike price of ₹160 for a ₹3 premium. If the stock stays below ₹160 by expiration, they keep the premium as profit while retaining their shares.
While this strategy reduce overall portfolio risk and enhance returns through premium collection, it is not without challenges. If prices move sharply against both positions (e.g., if a sold call’s underlying asset surges unexpectedly), losses compound rather than offset each other.
This hedging technique requires precise execution and an understanding of correlations between assets. It is particularly useful for advanced traders seeking to balance portfolio risks while generating additional income through premiums.
Naked option trading strategies—such as premium collection, volatility trading, and hedging—offer unique opportunities for experienced traders willing to take on substantial risks. These strategies generate consistent income through premiums, capitalize on market volatility for speculative gains, or serve as hedging tools within broader portfolios.
What are The Risks Involved in Naked Option Trading?
Naked option trading, while offering opportunities for high returns, comes with significant risks due to the absence of a hedge or protective position. Below are the primary risks associated with naked options.
- Unlimited Loss Potential
One of the most significant risks of selling naked options, particularly naked calls, is the potential for unlimited losses. When a trader sells a naked call, they are obligated to sell the underlying asset at the strike price if the option is exercised. If the price of the underlying asset rises significantly, there is no cap on how high it go, leading to theoretically unlimited losses.
For example, a trader is selling a naked call with a strike price of ₹100 and the stock surges to ₹200, they would incur a loss of ₹100 per share (minus the premium received). Similarly, selling naked puts lead to substantial losses if the underlying asset’s price falls drastically. While losses in naked puts are limited to the strike price minus the premium (as prices cannot fall below zero), they are still financially devastating.
- Margin Calls and Liquidity Risks
Naked options require significant margin reserves due to their high-risk nature. If the market moves against a trader’s position, brokers may issue margin calls, requiring additional funds to maintain the position. Failure to meet these margin requirements result in forced liquidation at unfavorable prices, compounding losses.
Margin calls often occur during periods of heightened volatility when liquidity may already be constrained, making it difficult for traders to manage their positions effectively. This risk underscores the importance of maintaining sufficient capital reserves when trading naked options.
- Market Direction Mismatch
Naked options rely heavily on accurate predictions of market direction and timing. A misjudgment in forecasting the movement of the underlying asset lead to rapid capital erosion. For instance, if a trader sells a naked call expecting the stock price to remain flat or decline but instead it rises sharply, they face significant losses.
Similarly, selling a naked put in anticipation of stable or rising prices result in losses if prices drop unexpectedly. This directional risk is amplified as expiration approaches since options become more sensitive to price changes (higher gamma), leaving little room for error.
These risks make it unsuitable for inexperienced or risk-averse investors and demand robust risk management strategies from traders.
How Margin is Calculated for Naked Option?
Margin requirements for naked options are calculated to ensure traders have sufficient collateral to cover potential losses.
The margin formula varies depending on the broker and the type of underlying asset, but it generally includes a combination of the option premium, a percentage of the underlying asset’s market value, and adjustments for out-of-the-money amounts.
Can Beginners Trade Naked Options?
Naked options are generally not suitable for beginners due to their high-risk nature and complexity. Selling naked options exposes traders to substantial risks, including unlimited losses for naked calls and significant losses for naked puts if the market moves unfavorably.
Brokers often restrict access to naked options trading, requiring traders to meet specific experience levels, financial criteria, and margin requirements. In the stock market, beginners typically lack the expertise to manage these risks effectively and are better suited to less risky stock market strategies like covered calls or debit spreads.
Is Naked Option Trading Legal?
Yes, naked option trading is legal in most markets but is subject to strict regulations. In India, retail investors are prohibited from trading naked options due to their speculative and high-risk nature. Only institutional investors or high-net-worth individuals (HNIs) are allowed to trade naked options under specific conditions.
IIn jurisdictions where option trading is permitted, traders must meet broker-imposed requirements, including margin deposits and account clearance levels. Successful option trading also demands a clear understanding of the associated risks and mechanics.
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