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Uncovered Option What It Is and How It Works

Uncovered Option What It Is and How It Works

Uncovered Option: What It Is and How It Works

What Is an Uncovered Option?

In option trading, "uncovered" refers to an option without an offsetting position in the underlying asset. Uncovered options are written options, or sell orders. This is also known as selling a naked option.

Key Takeaways

  • Uncovered options are sold options without a position in the underlying security.
  • Selling this kind of option creates the risk of needing to acquire a position in the security when the option buyer wants to exercise it.
  • The risk of an uncovered option is that the profit potential is limited, but the loss potential may be multiple times the greatest profit.

How an Uncovered Option Works

Traders who sell an option have a potential obligation. That obligation is covered by having a position in the underlying security. If the trader sells the option without a 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 it. However, those who sell these options have an obligation to provide a position in the underlying asset if the buyers choose to exercise them.

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Risks With an Uncovered Options Strategy

An uncovered put strategy is risky because of the limited upside profit potential and the significant downside loss potential. The maximum profit is achievable if the underlying price closes at or above the strike price at expiration. The maximum loss is theoretically significant because the price of the underlying security can fall to zero.

The higher the strike price, the higher the loss potential with uncovered puts.

An uncovered call strategy is also risky, with limited upside profit potential and theoretically unlimited downside loss potential. Maximum profit is achieved if the underlying price falls to zero. The maximum loss is theoretically unlimited because there is no cap on how high the price of the underlying security can rise.

An uncovered options strategy is the opposite of a covered options strategy. A covered put involves keeping a short position in the underlying security, and the puts are sold or shorted in equal quantities. The only difference between a covered put and a covered call is the underlying position – short instead of long.

However, in practice, sellers of uncovered puts or calls will likely repurchase them well before the price of the underlying security moves too far from the strike price.

Using Uncovered Options

Uncovered options are suitable for experienced investors who understand the risks and can afford losses. Margin requirements are high for this strategy due to potential significant losses. Investors who believe the price of the underlying security will rise, fall, or stay the same can write options to earn premiums.

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With uncovered puts, if the stock is above the strike price between the option’s writing and expiration, the writer keeps the premium, minus commissions. With uncovered calls, if the stock is below the strike price between writing the option and expiration, the writer keeps the premium, minus commissions.

The breakeven point for an uncovered put option is the strike price minus the premium. The breakeven for the uncovered call is the strike price plus the premium.

Example of an Uncovered Put

If the price of the stock falls below the strike price before or on the expiration date, the buyer can demand the seller take delivery of shares. The seller must sell the shares in the open market at a loss even though they paid the strike price. For example, if the strike price is $60 and the open market price is $55 at exercise, the seller incurs a loss of $5 per share.

How Risky Is an Uncovered Call Option?

Uncovered call options are very risky. The profit potential is limited, while the loss potential is 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 premiums without putting up a lot of capital. However, there is a risk that the underlying security doesn’t perform as expected, and the options seller must quickly acquire a position at any price.

Are Uncovered Calls Worth It?

When deciding whether uncovered calls are worth it, it’s important to remember that the reward is unlikely to outweigh the unlimited risk in these scenarios.

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The Bottom Line

Uncovered options are written options without a position in the underlying security. Selling uncovered options is a risky strategy because the seller may need to quickly acquire a position if the buyer exercises the option. Furthermore, the profit potential is capped with uncovered options, but the potential for loss is not.

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