The concept of a naked position is eyebrow-raising and can be quite suggestive.
In the world of options, a naked call or naked put describes an outcome when we write options without having any protection or offsetting positions. An offsetting position satisfies the requirements of assignment.
Since a naked put is directionally opposite of a naked call, the requirements for the underlying changes.
The goal for writing naked options is to take payment of the premium from the option buyer and hope the option is never exercised. Let's get our minds out of the gutter and explore the pros and cons of this basic strategy.
Reasons why investors use the strategy
Investors use naked options to accomplish a few goals
- Short theta
- Option legs for complex strategies
- Synthetic option strategies
An advantage to selling a naked call or naked put option is to create negative or short theta positions. We learned that theta decay results in a loss of value over time for an option holder, and also understand that options are zero-sum so thus the seller of the options collects that lost value over time. Combined with the low cost and simplicity of being able to sell a naked option while owning nothing else in our brokerage account, investors use this strategy to capture theta.
Naked calls and puts are used as a singular component in multi-option strategies, e.g. a butterfly. Multi-option strategies are complex and won't be covered in the current scope.
Lastly, short option positions are used to create synthetic positions. For example, we can have the economic benefits of owning stock without owning the underlying by combining options.
It's important to note that short naked positions are often used in combination. We'll cover synthetics and advanced spreads like butterflies in future lessons.
Pitfalls to avoid
Naked calls and naked puts expose us to much larger potential losses than if we had just bought call or put options.
Naked calls are the riskiest.
In the profit diagram above, we can see that the maximum profit is capped at the premium we receive for the option. However, if the stock price starts going up and the call option we sold is now in-the-money, there is no limit to the amount of money we can lose.
Naked calls expose us to the risk of huge losses while only offering limited profit. For beginners, using this strategy as a stand-alone is extremely risky and should generally be avoided.
Similar to a naked call, the disadvantage is that naked puts can be very risky with limited potential for profit. However, a naked put is slightly less risky.
One major advantage that a naked put has over a naked call is that underlying prices cannot drop below $0. So there is an eventual cap to the amount we can lose with a naked put. You might be thinking, that this payoff diagram looks a lot like the covered-call payoff diagram. This is because a naked put provides the same outcome as a covered call with the same strike price and premium due to put-call parity.
Introduction to put-call parity
If we revisit the synthetics example above, we can see that we're actually looking at a simple algebraic equation. This equation is the basis for put-call parity and allows us to re-create different synthetics.
|A list of possible synthetics|
|Short Stock||=||Short Call||+||Put|
|Short Call||=||Short Stock||+||Short Put|
|Short Put||=||Stock||+||Short Call|
Starting out, we should avoid naked strategies altogether. If we are looking to get paid when the stock price goes up (naked put), we should just buy a call option. If we are looking to get paid when the stock prices go down (naked call), we should just buy a put option. In both cases our losses are limited, and our potential gains are not capped. Being able to recognize naked calls and puts is important for us to avoid them for now. We will learn in future lessons how to combine naked options with other strategies to improve the risk and reward profile.