how an uncovered option works
any trader who sells an option has a potential obligation that obligation is met or covered by having a position in the security that underlies the option if the trader sells the option but has no position in the underlying security then the position is said to be uncovered or naked traders who buy a simple call or put option have no obligation to exercise that option however those traders who sell those same options have an obligation to provide a position in the underlying asset if the traders to whom they sold the options do exercise their options this can be true for put or call options 1an uncovered or naked put strategy is inherently risky because of the limited upside profit potential and at the same time holding a significant downside loss potential theoretically the risk exists because maximum profit is achievable if the underlying price closes at or above the strike price at expiration further increases in the cost of the underlying security will not result in any additional profit the maximum loss is theoretically significant because the price of the underlying security can fall to zero with uncovered puts the higher the strike price the higher the loss potential an uncovered or naked call strategy is also inherently risky as there is limited upside profit potential and theoretically unlimited downside loss potential maximum profit will be achieved if the underlying price falls to zero the maximum loss is theoretically unlimited because there is no cap on how high the price of the underlying security can rise an uncovered options strategy stands in direct contrast to a covered options strategy when investors write a covered put they will keep a short position in the underlying security for the put option also the underlying security and the puts are sold or shorted in equal quantities a covered put works in virtually the same way as a covered call the exception is that the underlying position is a short instead of a long position and the option sold is a put rather than a call 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 using uncovered optionsuncovered options are suitable only for experienced knowledgeable investors who understand the risks and can afford substantial losses margin requirements are often quite high for this strategy due to the capacity for significant losses 2 investors who firmly believe the price for the underlying security usually a stock will rise in the case of uncovered puts or fall in the case of uncovered calls or stay the same may write options to earn the premium with uncovered puts if the stock persists above the strike price between the option s writing and the expiration then the writer will keep the entire premium minus commissions the writer of an uncovered call will keep the whole premium minus commissions if the stock persists below the strike price between writing the option and its expiration the breakeven point for an uncovered put option is the strike price minus the premium breakeven for the uncovered call is the strike price plus the premium this small window of opportunity would give the option seller little leeway if they were incorrect example of an uncovered put