A naked option, also known as an uncovered option, is an options contract where the seller (also known as the writer) does not hold a corresponding position in the underlying asset. In other words, the seller has not hedged their risk by owning the underlying asset or a related derivative.
For example, if an investor sells a naked call option, they are obligated to sell the underlying asset to the buyer at the strike price if the buyer exercises their option. If the underlying asset rises significantly in price, the seller of the naked call option could face significant losses as they would be required to buy the asset at the current market price and sell it at the lower strike price.
Naked options can be risky for sellers as they are exposed to potentially unlimited losses, particularly in volatile markets. Because of this risk, naked options are typically only sold by experienced traders and are subject to strict margin requirements by brokers.
Investors should carefully consider their risk tolerance and investment objectives before buying or selling naked options. It is generally recommended that investors limit their exposure to naked options and instead use options as part of a broader hedging or trading strategy.