What are naked options and why are they risky?

A holder of a call option has the right, but not the obligation to buy an underlying share at a specified price, whilst the holder of a put option has the right, but not the obligation to sell the underlying share at a specified price.

The process of selling new options is called ‘writing’. When writing a call option, the writer agrees to sell the underlying stock at a specific price. When the person who is writing this option does not hold the underlying stock it is referred to as writing a naked call option.

The major risk associated with writing a naked call option is that if the stock rallies above the strike price of the sold call option, then the writer of the option must buy the underlying share at a higher price on the market to make delivery at the lower price to the holder of the option. The higher the share price, the more money required to buy the underlying stock to make delivery to the option holder. Thus the risk is unlimited as to how high the stock price may get, and as such how much the writer will need to pay to buy it.

When writing a put option, the writer has undertaken to buy the underlying stock from the option holder at a specific price. A naked put option is when the writer of the option does not have the full funds required in order to pay for the underlying stock from the option holder at the agreed price.

The risk associated with writing a naked put option is in the event the share price drops below the strike price of the written option, whereby the option holder is now better off selling their shares to the writer of the option at the strike price, rather then on the market, as the market price is lower. The lower the underlying share price goes, the less the option writer can then re-sell the shares for which were bought from the holder of the put option. Therefore the major risk is the share price falling to 0, which would leave the option writer with the obligation to buy stock from the option holder that, in effect, has no value on the underlying market.

An example would be for an investor to sell naked puts on BHP with a strike price of $35, expiring in October. For selling the put the investor receives $1.40 per share. If the share price stays above $35 the option will expire worthless leaving the investor with a profit of $1.40 per share.

If the shares fall to $30 the investor would be forced to buy the shares at $35 and would only be able to sell them at $30, incurring a $5 loss per share. This loss would be partially offset by the initial premium received. The further the shares fall the more the investor will lose. If the shares fell to $20 the investor would lose $15 per share.

By Matt Comyn, General Manager, CommSec

Disclaimers: The views expressed in this article are those of Matt Comyn, a representative of Commonwealth Securities Limited (CommSec) ABN 60 067 254 399 AFSL 238814. Commonwealth Securities Limited (CommSec) ABN 60 067 254 399 AFSL 238814 is a wholly owned but non-guaranteed subsidiary of the Commonwealth Bank of Australia ABN 48 123 123 124 and a Participant of the ASX Group and the Sydney Futures Exchange. As this information has been prepared without considering your objectives, financial situation or needs, you should, before acting on this information, consider its appropriateness to your circumstances and if necessary, seek appropriate professional advice. Exchange Traded Options are issued by Commonwealth Securities Limited ABN 60 067 254 399 AFSL 238814. A Product Disclosure Statements is available by calling 13 15 19 (8am-7pm Monday to Friday, EST) or by visiting commsec.com.au. You should consider the appropriate PDS before making any decisions about the products.