Just like with any speculative approach to trading, selling naked calls or puts can have its advantages and disadvantages, but one thing you should know is that a “naked” strategy is as aggressive and high risk as its name implies, with repercussions that could follow, if stop losses or other mechanisms are not used to provide some level of protection.
In essence, a naked call or put involves the forced sale or purchase of stock or cash based futures which you don’t own. You are selling someone or buying from someone the right to an instrument at a predetermined price and for a certain amount of time, without you actually owning the instrument.
In a naked call, when the stock rises above the strike price at expiration, the option seller is forced to buy the stock at the market price, and then sell it at the strike price, thus experiencing a loss. Anytime the owner of the call decides to exercise his/her right, you would have to purchase the asset at the predetermined price before the expiration, ending up with a short position and having to sell at a loss. Because of this, as long as the underlying asset stays below the strike price, even though profits remain limited, you are safe, however, if the price rises above the strike price, you not only forfeit profiting from the premium, but losses can add up quickly and without limit. You can see why limited profits versus unlimited risk might be an unattractive concept.
A naked put carries slightly lower risk than a naked call, however, the strategy still has limited potential gain, and significant potential loss. Let’s say you execute a naked put by selling a put option with a strike price lower than the market price. If the stock expires at a price lower than the strike price, and the option is exercised, the seller of the put option is obligated to buy shares of the stock at the strike price instead of at the lower market price. You would write a naked put option when you expect the asset to trade above the strike price at expiration, but the risk from this strategy heavily outweighs its potential rewards.
Just like with covered calls, naked calls are sometimes recommended to be written when stock prices are moving down and puts when stock prices are moving up in order to improve your probability of profiting.
You might be enticed by the promise of big wins, and while a naked strategy can be used successfully as part of a diversified portfolio to generate significant income, it can also have devastating results well beyond your portfolio. You see, buying naked exposes you to unlimited risk and unlimited losses, requires high margins, and places you in a position where the market can move against you rapidly and considerable swings in price can cause significant amounts of drawdown to your account. With the unbalanced risk versus reward of naked calls and puts, we recommend a solid money management strategy and risk control.
Even the most savvy and knowledgeable investors, with nerves of steel and solid risk management strategies, offset their risk when trading naked options by purchasing another underlying asset or call. This strategy utilizing covered calls and covered puts, can potentially allow you to increase profits and limit losses, hence balancing out the risky approach of trading naked.