Investing Answers Building and Protecting Your Wealth through Education Publisher of The Next Banks That Could Fail
Investing Answers Building and Protecting Your Wealth through Education Publisher of The Next Banks That Could Fail

Uncovered Option

What it is:

Also known as “being naked,” an uncovered option is the sale of an option involving securities the seller does not own. It is the opposite of a covered option.

How it works (Example):

For example, the safest way to sell an option is to write a covered call. In this type of trade, the investor sells a call option on an underlying stock that he/she already owns. In an uncovered call option, the seller sells the call option on a stock that he/she doesn’t own.

For example, assume that in January IBM stock trades at $100. Over the course of the next month, the investor does not believe that IBM will trade for more than $105. With this expectation, the investor would be wise to sell an option contract on IBM for $105 to another investor who feels differently. Suppose an IBM option sells for $3. The investor who writes the option will therefore receive $3 today (or $300 total, since each option represents an interest in 100 underlying shares) in exchange for selling the option (even though the option does not expire until next month).

Now consider the following scenarios:
IBM trades at $110 at expiration. In this scenario, the writer was too conservative in his estimate of where IBM would trade this month. The writer therefore has to sell 100 shares to the buyer of the call option for $105 each, but he has to go out into the market and get those shares first. So essentially, he has to buy shares for $110 and sell them for $105.
IBM trades at $103 at expiration. In this scenario, the writer was accurate in his/her estimate. However, the buyer probably won’t exercise the option. (Who wants to pay $105 for shares when you can go out and get them in the open market for just $103?) That means the seller just keeps the $3 he got for selling the option in the first place.
IBM trades at $125 at expiration. In this scenario, the investor really underestimated the return on the stock. The end result is the same as the first scenario, but worse. The buyer will exercise the option to buy IBM shares at $105, but the seller has to go out and get those shares first. And for that he has to pay $125 a share. As you can see, the more you’re wrong, the more it hurts.

Why it Matters:

In particular, the uncovered option strategy works best when the investor practically has a crystal ball. Otherwise, the investor faces unlimited downside potential. In other words, it’s a very risky strategy, which is why naked options are mainly used for speculating. The investor must be very confident about the direction the stock will go and have the resources available to cover any mistakes.