Usually, while derivatives trading, you need to have a certain quantity of the underlying financial asset to write a contract. However, using naked options, you can make trades without owning underlying financial assets. Read to know how to profit from naked options.
Naked Options – A Deep Dive
Naked options are derivatives financial agreements which have no underlying assets. Speculators generally use these instruments to earn profits by predicting market movements. Like traditional derivatives contracts, these investment vehicles also have call and put options.
The call option gives investors the right to buy a set quantity of the underlying asset at the strike price before expiration. If the security’s price rises, they stand to profit from this transaction. Buyers also need to pay an options premium to enter this agreement.
Similarly, the put option will provide traders with the right to sell the underlying financial instrument at the strike price upon expiry. They purchase this option to secure gains from a depreciation in the underlying asset’s market price.
How to Settle Naked Options?
When you are planning to settle naked options, these are the processes you can choose:
- Squaring Off Your Position
While settling naked options, you can square off your position by purchasing contracts that can nullify the transaction. Moreover, as this process involves buying two options at separate times, their prices will differ. It is based upon this difference that you stand the chance of making a profit or a loss.
- Expiring Worthlessly
If you are a naked options holder or buyer, you have the right but not the obligation to buy or sell the asset upon contract expiry. So, you can simply ignore the agreement and let it expire worthlessly.
However, if you are an options writer or seller, you cannot avail this option.
- Physical Settlement
In case the options buyer exercises the right, the seller is under obligation to deliver the underlying asset. But, as that individual does not have the security, he/she must purchase it from the cash segment in order to facilitate delivery.
Naked Options vs Covered Options
The key difference between naked options and covered options is that in case of the former, the options writer does not have the underlying asset, while in case of the latter, the options writer owns the underlying security.
Naked options come in handy when traders want to freely speculate market price movements, whereas covered options are used by people to act as a hedge against price fluctuations.
What Are the Benefits of Trading Naked Options?
Some of the benefits of trading naked options are as follows:
- To trade naked options, there are no barriers to entry. Thus, many speculators can enter or exit these contracts at their will to make trading gains. This, in turn, facilitates higher liquidity in options.
- Investors can take larger positions with lower amounts of capital. This is because the cost of purchasing naked options is approximately 3% to 4% of the underlying asset’s notional value. Hence, its upfront expenses are much lower in comparison to other derivatives contracts.
As you do not own the underlying asset, trading in naked options can be a high-risk investment strategy. However, if your risk appetite permits and you can conduct thorough market research to predict future price movements, there are chances of making significant gains from this strategy.
Frequently Asked Questions
Q1. What are the risks of naked options trading?
Ans. As naked options are speculative in nature, your chances of making profits or losses will depend entirely on market movements. Additionally, if you make significant losses, some brokerage firms may compel you to liquidate some of your profitable holdings in order to cover the gap.
Q2. What are the things to remember before trading naked options?
Ans. Before you trade naked options, you must have thoroughly researched and be sure of the asset’s future price movements before entering into a contract. Furthermore, you should also consider using a stop-loss order to protect yourself against unlimited losses.
Q3. Do I need a Demat account for trading naked options?
Ans. Yes, you need a Demat account for trading naked options. This is because if there is an option exercised by the buyer, you will have to deliver the underlying asset. To do that, you need a repository to store that security in order to facilitate delivery. A Demat account will fulfil that role.
Q4. When is it suitable to invest in naked options?Ans. You can consider investing in naked options when you are bullish on the stock or index prices movement direction.And, if the market turns against you, you may attempt to rescue the situation by acquiring similar but opposing options.
Krishna is an investment professional with a demonstrated history of working in Debt Capital Markets. He has completed his B.E. (Hons) in Computer Science Engineering from BITS Pilani and MBA (Finance) from JBIMS, Mumbai. He is currently working as Investments Principal at Wint Wealth. Previously he worked at Kotak Mahindra Bank at their DCM desk and Northern Arc Capital at their Structured Finance desk.