Glossary
Naked option
Selling an option without owning the underlying or an offsetting position; a naked call has theoretically unlimited risk.
A naked, or uncovered, option is one that has been sold without a position that offsets its risk. A naked call is written by someone who does not own the underlying shares; a naked put by someone who has not set aside the cash to buy the shares, or does not hold a protective position. The seller collects the premium up front and keeps it if the option expires worthless, but takes on large, sometimes unlimited, losses if the price moves the wrong way.
Why the risk is lopsided
Margin and approval
Brokers require collateral for naked options, and the requirement rises as the option moves against the seller. A common formula for a short equity option is 100% of the option's current value plus 20% of the underlying's value, minus any amount it is out of the money, with a minimum of 10% of the underlying (calls) or of the strike (puts). Firms often set higher requirements.
Under FINRA Rule 2360, accounts must be approved for options before trading, and uncovered writing requires a special written statement describing its risks. Most firms reserve naked selling for their highest approval level. A sudden gap, such as one after earnings, can create losses faster than a margin call can be met.