If you have been reading about options trading, you must know the basics of trading options. You must know that options are derivative contracts that give the buyer the right to transact the underlying asset at a predetermined price. The options buyer has the right to buy or sell the asset, depending on whether the option contract is a call or a put. You may also be familiar with terms like premium, expiry, and lot size
In this article, however, we will discuss options selling, the lesser discussed part of options trading. As an options seller, you must fulfill the buyer’s rights. So, if the buyer exercises a call contract, as an options seller, you have to sell the underlying asset. Likewise, if the buyer exercises a put, you must buy the underlying asset. In this article, we learn about two important aspects of options selling “naked options” and “covered options”. Learn how to trade in futures and options and profit from price fluctuations only at Share India.
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What are Naked Options?
An options contract is considered “naked” if the options seller does not have the underlying asset to meet their potential obligations. In other words, the seller of naked options, also called uncovered options, is the person who enters into the contract without owning the underlying asset. Since the trader does not possess the underlying asset when they sell the option, this option-selling strategy is considered risky. That is because not owning the asset leaves them exposed to unlimited losses. At the same time, their profits are only limited to the premium they receive for selling the contract. Our options calculator is a powerful tool that can help you make informed decisions about your options trades.
How Do They Work?
Naked options can be of two types—naked calls and naked puts.
If you sell a naked call option, you have undertaken the obligation to sell the underlying asset at the agreed-upon strike price if the buyer exercises their right on expiration. Since you don’t own the asset, you will first have to buy the asset at the current market price and then sell it to the buyer at the strike price.
On the other hand, in the case of naked puts, you have agreed to buy the underlying asset at the strike price if the buyer of the put decides to exercise their right and sell the underlying asset upon expiry. In this case, you don’t need to have the underlying asset but must have the ability to secure funds to purchase the assets at the agreed-upon strike price.
What are Covered Options?
As opposed to naked options, covered options are backed by an equivalent amount of the underlying asset. In other words, a trader selling a covered option already owns the quantity of the stock they would have to transact if the option buyer decided to exercise their buying right. So, in this case, if the price moves in an unfavorable direction, since they already hold the underlying asset, the seller can offset their losses. Hence, it is relatively less risky than trading or selling an uncovered option.
How do covered options work?
Covered options selling is mainly observed in the case of call options. Like a naked call, if you sell a covered call, you are also undertaking the obligation to sell the underlying asset at the agreed-upon strike price if the buyer exercises their right on expiration. The only difference is, in this case, you don’t have to buy the asset at the current market price if the buyer exercises the contract since you already hold a long position in the underlying asset. Checkout our options calculator and make informed decisions about your trading strategies.
Uncovered Options vs. Covered Options
Selling covered options is relatively less risky than selling naked options. Let’s understand that by looking at the following example.
Assume the strike price for a call stock option is Rs.100 per share when you sell the contract. On the expiration date, the stock trades at Rs.150, and the options buyer decides to exercise their right to purchase the stock. At the same time, don’t forget that you won’t be selling a single share, but you are obliged to sell the number of shares specified as per the lot size; a single lot could have multiple shares, in this case, assume it’s 1,000.
Case 1: You sell the contract uncovered or naked; you don’t own the stock. In this scenario, as a seller of a naked call, you would have to buy the stock at Rs.150 and sell it at Rs.100. You incur a loss of Rs. 50 on 1,000 shares.
Case 2: You already hold 1,000 shares of the company and sell a covered call. Assume your average buying price of the 1,000 shares is Rs.95.So, even if the expiration date price is Rs. 150, you will technically not lose any money because you are selling per share at Rs. 100. You may lose your profits, but may still end up selling the stock above your average buying price.
From the above example, you can see how selling covered calls is a lot less risky than selling calls. Traders consider selling naked puts a less risky trading strategy compared to selling naked calls since the trader already knows the maximum risk they are undertaking. That maximum risk would be the lot size at the strike price of the contract plus the brokerage. However, in the case of naked calls, the risk is unlimited; in the above example, the stock could be trading at Rs. 150, or it could even be trading at Rs.250. In other words, the upside potential is limitless.
However, the downside of selling covered options is that you must have the financial ability to own the underlying asset in the right quantity. Not many traders in India can afford to park lakhs of rupees in a single share. What’s more, even if you are able to purchase that stock in the required quantity, you may not have the funds to take advantage of other trading opportunities since most of your capital is deployed into a single stock.
To conclude, both uncovered and covered options have their advantages and disadvantages. While selling covered options carries less risk, only a few traders have the funds to sell covered options. In contrast, more traders can partake in uncovered or naked call selling. And many do so because many options expire worthless. You must understand the risks and engage in options trading only with proper risk management strategies.