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If you’re familiar with the fundamentals of options trading, you understand their role as derivative contracts granting the right to buy or sell the underlying asset at a predetermined price. In this exploration of options selling, we delve into the intricacies of fulfilling buyer’s rights, navigating concepts like naked options and covered options. Understanding these aspects is crucial for effective risk management and optimising returns in the dynamic landscape of financial markets. You can further explore these nuances with us at Share India.
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. This 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.
- Share India’s options calculator is a powerful tool that can help you make informed decisions about your options trades.
Understanding the Working of Naked Options
Naked options can be of two types—naked calls and naked puts.
Naked Calls
If you sell a naked call option, you undertake 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.
Naked Puts
In the case of naked puts, you agree 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.
In this case, if the price moves in an unfavourable 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.
Understanding the Working of Covered Options
Selling of covered options 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.
- Check out Share India’s 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 that the strike price for a call stock option is ₹100 per share when you sell the contract. On the expiration date, the stock trades at ₹150, and the options buyer decides to exercise their right to purchase the stock.
- 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 ₹150 and sell it at ₹100. You incur a loss of ₹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 ₹95. So, even if the expiration date price is ₹150, you will technically not lose any money because you are selling per share at ₹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. This maximum risk is the lot size at the strike price of the contract plus the brokerage. However, in the case of naked calls, the risk is unlimited.
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.
Conclusion
In essence, the key distinction between naked options and covered options lies in the level of risk and obligation for the options seller. Naked options involve selling options contracts without owning the corresponding underlying asset, exposing the seller to unlimited risk. On the other hand, covered options involve selling options while holding the underlying asset, providing a level of risk mitigation. While naked options offer higher profit potential, they come with greater risk. Covered options, though offering limited profit, provide a more conservative approach with a safety net against potential losses. The choice between the two strategies depends on an investor’s risk tolerance and market outlook.