What is a Naked Position?
In securities trading in general, a naked position refers to a securities position, long or short, that is not hedged from market risk. Both the potential gain and the potential risk are greater when a position is naked instead of covered or hedged in some way. In options trading this phrase specifically refers to an option sold by a trader without an established position in the underlying security.
- A naked stock position is a position that is not hedged.
- This phrase is more often associated with short-selling stocks.
- A naked position is also commonly used to referred to an option that is sold without a position in the underlying security as protection against the risk of option assignment.
Understanding a Naked Position
A naked stock position does not have the hedging associated with a call or put option or perhaps an opposite position in a related stock. For example, a long in Coke and a short in Pepsi.
A naked position is inherently risky because there is no protection against an adverse move. Most investors do not consider owning stocks to be excessively risky, especially because in most cases it is easy to sell the position back to the market. However, a declining market for an investor holding a long position in a stock still has the potential to deliver significant losses. In this case, holding a put option against the long stock position could, for a small price, cap losses to a manageable amount.
The investor’s profit potential, before commissions, would be reduced by the premium, or cost, of the option. Consider it to be an insurance policy the investor hopes never to use.
Investors selling stocks short without hedges face even greater risk since the upside potential for a stock is theoretically unlimited. In this case, owning a call on the underlying stock would limit that risk.
In the options market, uncovered or naked calls and puts also have risk. In this case, it is the options seller, or writer, that has no hedge against being assigned. Options buyers only risk the amount paid to buy the options, which is normally significantly less than the amount needed to purchase actual shares of stock or another underlying asset.
Options sellers, on the other hand, can have unlimited risk if not hedged. For example, an investor sells a call option on a stock and that stock soars higher in price before expiration. The options buyer could likely exercise the option, forcing the seller to go out into the open market to buy the stock at the higher price in order to deliver it to the options buyer. If the options seller owned an offsetting position in the underlying stock, his or her risk would be limited.
Put sellers would have nearly unlimited risk should the underlying security fall towards zero. A corresponding short position in the underlying stock would limit that risk.
However, in more practical terms, the seller of uncovered puts or calls will likely repurchase them well before the price of the underlying security moves adversely too far away from the strike price, based on their risk tolerance and stop loss settings.
More advanced options traders can hedge risk with multiple positions of puts and calls, called combinations.