Island Reversal

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Definition / Meaning of

Naked Option

Categories: Options, Investing and Trading, Stocks, Legal, ,

When you write, or sell, a call option but don't own the underlying instrument, such as a stock in the case of an equity option, the option is described as naked. Similarly, you write a naked put if you don't have enough cash on hand or in liquid investments to purchase the underlying instrument. Because you collect a premium when you sell the option, you may make a profit if the underlying instrument performs as you expect, and the option isn't exercised. The risk you run, however, is that the option holder will exercise the option. In the case of a call, you'll then have to buy the instrument at the market price in order to meet your obligation to sell. Or, if it's a put, you'll have to come up with the cash to purchase the instrument. If that price of the underlying has moved in the opposite direction from the one you expected, meeting your obligation could result in a substantial net loss. Because of this risk, your brokerage firm may limit your right to write naked options or require that you write them in a margin account.