What Is an Uncovered Option?
In option trading, the term “uncovered” refers to an option that does not have an offsetting position in the underlying asset. Uncovered option positions are always written options, meaning options where the initiating action is a sell order. This is also known as selling a naked option.
Key Takeaways
- Uncovered options are written, or sold, options where the seller does not have a position in the underlying security.
- Selling this kind of option creates the risk that the seller may have to quickly acquire a position in the security when the option buyer wants to exercise the option.
- The risk of an uncovered option is vast: while the profit potential is limited, the loss potential can be multiple times the greatest profit that can be made.
How an Uncovered Option Works
Any trader who sells an option has potential obligations. That obligation is met, or covered, by having a position in the security that underlies the option. If the trader sells the option but has no position in the underlying security, then the position is uncovered, or naked.
Traders who buy a simple call or put option have no obligation to exercise that option. However, those traders who sell those same options have an obligation to provide a position in the underlying asset if the traders to whom they sold the options do exercise their options. This can be true for put or call options.
Risks With an Uncovered Options Strategy
An uncovered or naked put strategy is inherently risky because of the limited upside profit potential while holding significant downside loss potential, theoretically. The risk exists because 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 significant because the price of the underlying security can fall to zero.
With uncovered puts, the higher the strike price, the higher the loss potential.
An uncovered or naked call strategy is also inherently risky, as there is limited upside profit potential and, theoretically, unlimited downside loss potential. Maximum profit will be achieved if the underlying price falls to zero. The maximum loss is theoretically unlimited because there is no limit to how high the price of the underlying security can rise.
An uncovered options strategy stands in direct contrast to a covered options strategy. When investors write a covered put, they maintain a short position in the underlying security for the put option. Also, the underlying security and the puts are sold or shorted in equal quantities. A covered put works similarly to a covered call. The exception is that the underlying position is a short instead of a long position, and the option sold is a put rather than a call.
However, in more practical terms, the seller of uncovered puts or calls will likely repurchase them well before the price of the underlying security moves adversely too far away from the strike price, based on their risk tolerance and stop loss settings.
Using Uncovered Options
Uncovered options are suitable only for experienced, knowledgeable investors who understand the risks and can afford substantial losses. Margin requirements are often quite high for this strategy, due to the capacity for significant losses. Investors who firmly believe the price for the underlying security (usually a stock) will rise, in the case of uncovered puts, or fall, in the case of uncovered calls, or stay the same may write options to earn the premium.
With uncovered puts, if the stock stays above the strike price between the option’s writing and the expiration, then the writer will keep the entire premium, minus commissions. The writer of an uncovered call will keep the whole premium, minus commissions, if the stock stays below the strike price between writing the option and its expiration.
The breakeven point for an uncovered put option is the strike price minus the premium. Breakeven for the uncovered call is the strike price plus the premium. This small window of opportunity gives the option seller little leeway if they were incorrect.
Example of an Uncovered Put
When the price of the stock falls below the strike price before, or by, the expiration date, the buyer of the options product can demand the seller take delivery of shares of the underlying stock. The options seller must go to the open market to sell those shares at the market price loss, even though the option writer paid the strike price. For example, imagine the strike price is $60, and the open market price for the stock is $55 at the time the options contract is exercised. The options seller will incur a loss of $5 per share of stock.
How Risky Is an Uncovered Call Option?
Uncovered or naked call options are extremely risky. The profit potential is limited, while the loss potential is theoretically unlimited; the price can only drop to zero, but it could rise almost infinitely.
What Are Uncovered Option Trading Strategies?
Uncovered option trading strategies benefit from collecting the premium without putting up a lot of capital initially. However, the risk lies in the underlying security not performing as expected, obligating the options seller to quickly acquire a position regardless of market price.
Are Uncovered Calls Worth It?
When evaluating whether uncovered calls are worth it, it’s crucial to remember that the reward is unlikely to outweigh the unlimited risk in these scenarios.
The Bottom Line
Uncovered options are written options where the seller does not own a position in the underlying security. Selling uncovered options is a high-risk strategy because the seller may be forced to quickly acquire a position if the buyer exercises their option. Furthermore, profit potential is capped with uncovered options, but the potential for loss is almost unlimited.
Related Terms: covered options, margin requirements, premium, strike price, exercise, open market.
References
- Cornell Law School Legal Information Institute. “Naked Option”.
- TD Ameritrade. “Margin Handbook”, Page 6.
