Legal Definitions - naked option

A naked option, also known as an uncovered option, is a financial contract where the seller grants another party the right to buy or sell an underlying asset (such as shares of stock) without actually owning or having control over that asset themselves. This means the seller is taking on a significant risk because if the buyer decides to exercise their option, the seller will be forced to acquire the asset at the current market price to fulfill their obligation. This can potentially lead to substantial financial losses for the seller if the market moves unfavorably.

There are two main types of naked options:

• Naked Call Option: The seller grants the buyer the right to purchase an asset at a specific price (the strike price) by a certain date, even though the seller does not own the asset. The seller hopes the asset's price will fall or stay below the strike price, causing the option to expire worthless.
• Naked Put Option: The seller grants the buyer the right to sell an asset at a specific price (the strike price) by a certain date, even though the seller does not have the cash or obligation to buy the asset readily covered. The seller hopes the asset's price will rise or stay above the strike price, causing the option to expire worthless.

Here are some examples illustrating how naked options work:

• Example 1 (Naked Call Option): A trader named Sarah believes that shares of "Global Tech Innovations Inc." (GTI) are currently overvalued and expects their price to decline in the coming weeks. To profit from this belief, she sells a call option for GTI shares with a strike price of $100, expiring in one month, even though she does not own any GTI stock. If GTI's stock price stays below $100 or drops, the option will likely expire worthless, and Sarah keeps the premium she received for selling it. However, if GTI unexpectedly announces a breakthrough product and its stock price surges to $120, the buyer of the call option will exercise their right to buy GTI shares from Sarah at $100. Sarah, not owning the shares, would then have to buy them on the open market at $120 per share to fulfill her obligation, resulting in a $20 loss per share (plus transaction costs).

• Example 2 (Naked Put Option): Mark, an investor, is very optimistic about "Green Energy Solutions Corp." (GES) and anticipates its stock price will rise significantly. He decides to sell a put option for GES shares with a strike price of $50, expiring in two months, without holding any GES stock or having the cash specifically set aside to buy them. He expects the price to stay above $50. If GES's stock price indeed rises or remains above $50, the put option will expire unexercised, and Mark profits from the premium. However, if GES faces an unexpected regulatory setback and its stock plummets to $35 per share, the buyer of the put option will exercise their right to sell GES shares to Mark at $50. Mark is then obligated to buy shares worth $35 on the market for $50 each, leading to a $15 loss per share.