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What Is an Uncovered Option?
Let me explain what an uncovered option is in option trading. The term 'uncovered' means an option without an offsetting position in the underlying asset. These are always written options, where you start by selling. You might hear this called selling a naked option.
Key Takeaways
Uncovered options are those you sell without holding the underlying security. When you sell one, you risk having to acquire the security quickly if the buyer exercises it. Remember, your profit is limited, but losses can multiply far beyond the maximum gain.
How an Uncovered Option Works
If you sell an option, you take on a potential obligation. That obligation is covered if you already have a position in the underlying security. But if you sell without that position, it's uncovered or naked.
Buyers of calls or puts have no obligation to exercise, but as the seller, you must provide the underlying asset if they do exercise. This applies to both puts and calls.
Risks With an Uncovered Options Strategy
An uncovered put strategy is risky due to limited upside and theoretically unlimited downside, since the underlying can drop to zero. You achieve max profit if it closes at or above the strike at expiration, but further rises don't add profit. Higher strike prices mean higher loss potential.
Uncovered calls are similarly risky, with limited profit if the price falls to zero, but unlimited losses as the price can rise indefinitely.
This contrasts with covered strategies, where for a covered put, you hold a short position in the underlying, selling equal quantities. It's like a covered call but with a short position and a put option.
In practice, you'll likely repurchase the option before the underlying moves too far against you, based on your risk tolerance and stop-loss settings.
Using Uncovered Options
Uncovered options suit only experienced investors who grasp the risks and can afford big losses. Margin requirements are high because of the loss potential. If you believe the stock will rise (for puts) or fall (for calls) or stay flat, you might write options to earn the premium.
For uncovered puts, if the stock stays above the strike until expiration, you keep the full premium minus commissions. For calls, the same if it stays below. The breakeven for a put is strike minus premium, and for a call, strike plus premium—giving you a narrow window if you're wrong.
Example of an Uncovered Put
Suppose the stock falls below the strike before expiration; the buyer can force you to take delivery. You buy at market price but deliver at strike, taking a loss. For instance, with a $60 strike and market at $55 on exercise, you lose $5 per share.
How Risky Is an Uncovered Call Option?
Uncovered calls are very risky; profit is limited, but losses are unlimited since prices can rise without bound, while dropping only to zero.
What Are Uncovered Option Trading Strategies?
These strategies let you collect premiums with little capital upfront, but the risk is acquiring the position at unfavorable prices if the underlying doesn't behave as expected.
Are Uncovered Calls Worth It?
When considering uncovered calls, note that the reward rarely outweighs the unlimited risk involved.
The Bottom Line
Uncovered options are written without owning the underlying, risking forced acquisition on exercise. Profits are capped at the premium, but losses can be extensive.
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