What is an uncovered option?
In options trading, the term “uncovered” refers to an option that has no offsetting position in the underlying asset. Uncovered option positions are always written options, or in other words options whose initial action is a sell order. This is also known as selling a naked option.
Key points to remember
- Uncovered options are options written or sold when the seller has no position in the underlying security.
- Writing this type of option creates the risk that the seller will have to quickly acquire a position in the security when the option buyer wishes to exercise the option.
- The risk of an uncovered option is that the potential for profit is limited, but the potential for loss can generate a loss that is many times the largest profit that can be made.
How an uncovered option works
Any trader who sells an option has a potential obligation. This obligation is satisfied, or hedged, by holding a position in the security underlying the option. If the trader sells the option but does not have a position in the underlying security, then the position is said to be uncovered, or naked.
Traders who purchase a simple call or put option have no obligation to exercise that option. However, traders who sell these same options have an obligation to provide a position in the underlying asset if the traders to whom they sold the options actually exercise their options. This can be true for put or call options.
an overdraft or naked strategy is inherently risky due to the limited number Upside down potential for profit, while theoretically holding a significant potential for loss. The risk exists because the maximum profit is achievable if the underlying price closes at or above the strike price at expiration. Further increases in the cost of the underlying security will not result in any additional profit. The maximum loss is theoretically large because the price of the underlying security can fall to zero. The higher the strike price, the greater the potential for loss.
an overdraft or naked call strategy is also inherently risky, as the profit potential is limited and, in theory, unlimited inconvenience loss potential. The maximum profit will be reached if the underlying price falls to zero. The maximum loss is theoretically unlimited as there is no limit to the rise in the price of the underlying security.
An uncovered options strategy is in direct contrast to a covered options strategy. When investors write a covered put option, they keep a short position in the underlying security of the put option. In addition, the underlying security and the put options are sold or shorted, in equal amounts. A covered put works much the same way as a covered call. The exception is that the underlying position is a short position rather than a long position and the option sold is a put option rather than a call option.
However, in more practical terms, the writer of uncovered puts or calls will likely repurchase them long before the price of the underlying security moves too far from the strike price, depending on his tolerance for the risk and stop loss settings.
Use of uncovered options
Uncovered options are suitable only for experienced and sophisticated investors who understand the risks and can afford substantial losses. Margin requirements are often quite high for this strategy, due to the ability to sustain significant losses. Investors who firmly believe in the price of underlying securitygenerally a stock, will rise, in the case of uncovered put options, or fall, in the case of uncovered call options, or remain unchanged may write options to earn the prime.
With uncovered put options, if the stock persists above the strike price between the subscription of the option and the expiration, the subscriber will retain the entire premium, less commissions. The writer of an uncovered call will keep the full premium, less commissions, if the stock remains below the strike price between the writing of the option and its expiration.
The break even for an uncovered put option is the strike price minus the premium. The break-even point for the uncovered call is the strike price plus the premium. This small window of opportunity would give the option seller little leeway if they were incorrect.
Example of an uncovered put
When the stock price falls below the strike price on or before the expiration date, the buyer of the options product may require the seller to take up shares of the underlying stock. The option seller must go to open market to sell those shares at market price, even if the option writer has paid the strike price. For example, imagine the strike price is $60 and the open market price of the stock is $55 at the time the options contract is entered into. exercised. The option writer will suffer a loss of $5 per share.
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