Legal Definitions - Uncovered option

An uncovered option (also known as a naked option) refers to an options contract where the seller does not own the underlying asset that they are obligated to deliver (in the case of a call option) or does not have a corresponding short position in the underlying asset (in the case of a put option). This strategy is considered high-risk because the seller faces potentially unlimited losses if the market moves significantly against their position, as they would have to acquire the underlying asset at market price to fulfill their obligation.

• Example 1 (Uncovered Call Option): Sarah believes shares of TechCorp, currently trading at $50, will remain stable or decrease in value. She decides to sell a call option with a strike price of $55, expiring in one month, for a premium of $2 per share. Crucially, Sarah does not own any shares of TechCorp. If TechCorp's stock price unexpectedly surges to $70 by the expiration date due to a positive earnings report, the buyer of the call option will exercise their right to purchase shares at $55. Sarah would then be obligated to buy shares on the open market at $70 to fulfill her commitment to sell them at $55, incurring a significant loss (minus the initial premium received). This is an uncovered option because Sarah sold a call option without owning the underlying TechCorp shares to cover her potential obligation to deliver them.

• Example 2 (Uncovered Put Option): David anticipates that the price of Global Metals stock, currently at $100, will not fall below $90. He sells a put option with a strike price of $90, expiring in three months, for a premium of $3 per share. David does not have a short position in Global Metals stock (meaning he hasn't borrowed and sold shares, hoping to buy them back cheaper). If Global Metals' stock price plummets to $70 by expiration due to a downturn in the commodities market, the buyer of the put option will exercise their right to sell shares to David at $90. David would be obligated to buy shares at $90 that are only worth $70 on the open market, resulting in a substantial loss (minus the premium received). This is an uncovered option because David sold a put option without having a short position in Global Metals stock to offset the risk of being forced to buy shares at a higher price than their market value.

• Example 3 (High-Risk Speculation): A speculative trader, Mark, sells a large number of uncovered call options on a volatile pharmaceutical stock, hoping to profit solely from the premiums. He believes the stock, currently at $20, will not exceed $25. However, an unexpected announcement of a highly successful clinical trial causes the stock to skyrocket to $100 overnight. Mark is now obligated to deliver shares at $25 to the option buyers. Since he doesn't own the shares, he must purchase them at $100 each on the open market to fulfill his obligation, leading to massive financial losses that far outweigh the initial premiums he collected. Mark's strategy involved selling call options without owning the underlying pharmaceutical stock, making them "uncovered." This exposed him to extreme risk when the stock price moved dramatically against his prediction, demonstrating the significant downside of such a position.