Lesson 8: Selling uncovered options

Uncovered option selling, also known as naked option selling, can be another tool in your overall option strategy.  

This approach differs from covered call selling in an important way. Uncovered call option sellers don’t hold the underlying asset and uncovered put option sellers don’t hold a short position in the asset. 

With this strategy, you collect the option premium with the belief that the underlying asset won’t move much or will move in a direction favourable to you — higher if you sell a put, lower if you sell a call.

This is a high-risk strategy that requires both frequent monitoring, to ensure you maintain an adequate margin balance, and trading discipline.

Call sellers of American-style options can be required to sell the stock at the strike price any time before or at option expiry. Because they don’t own the stock, uncovered call sellers could be forced to buy the stock at the current market price to meet their obligation.

The call seller’s risk of loss is unlimited because a stock can theoretically rise to any price.

Put sellers of American-style options can be required to buy the stock at the strike price any time before or at option expiry. During that period, the stock can drop substantially, although it can’t fall below zero — losses can be large but the maximum loss is calculable.

Remember that assignment of a short option might trigger a margin call if you don’t hold sufficient cash or account equity to support the stock position.

Uncovered option selling is only suitable for knowledgeable option investors who understand the risks and can afford the substantial losses that can occur if there’s a large, unfavourable movement in the price of the underlying asset.

You can decide to exit an uncovered option strategy before expiry, and before being assigned, by purchasing the option in the market at the prevailing market price, thereby closing out your short option position.

Let’s consider some scenarios that illustrate how an uncovered call option trade can result in a profit or loss.

Stock XYZ is trading at $75, and you don’t believe it will trade at more than $80 in the short term. You sell an uncovered call contract with a strike price of $80 to expire in 30 days. For selling the option contract, you’ll receive a premium of $2. Since a typical stock option contract is usually based on 100 shares of underlying stock, you’ll receive a total of $200, less commission.

In the 30 days that your uncovered call is open, the price of XYZ never reaches the $80 strike price and is trading at $78 on the expiration date.

It would not be profitable for the buyer to exercise the option to buy the stock at $80 when it's trading at only $78. The option expires worthless, and you keep the $200 premium as profit, excluding commissions.

In the 30 days that your uncovered call trade is open, the price of XYZ increases above the $80 strike price. It’s trading at $120 when the buyer exercises their right to buy the shares at the $80 strike price.

You’re obligated to sell the shares at the strike price, and you’re assigned a short position so that you can deliver the shares. If you have the margin available you can carry the short position as long as you want, though you will be assuming ongoing market risk while you remain short.

Your net loss will be based on the difference between the price where you were required to sell the shares, the $80 strike price, and the price where you ultimately buy back the short position.

If you close your short position at the current market price, your loss would be $3,800, excluding commissions and interest charged:

Proceeds: ($80 strike price × 100 shares) + $200 premium = $8,200

Cost: $120 market price × 100 shares = $12,000

Net loss: $8,200 proceeds − $12,000 cost = −$3,800

Let’s consider some scenarios that illustrate how an uncovered put option trade can result in a profit or loss.

Stock XYZ is trading at $75, and you don’t believe it will trade at less than $70 in the short term. You sell an uncovered put contract with a strike price of $70 to expire in 30 days. For selling the option contract, you’ll receive a premium of $2, for a total of $200, less commission.

In the 30 days that your uncovered put is open, the price of XYZ never drops to the $70 strike price and is trading at $72 on the expiration date.

It would not be profitable for the buyer to exercise the option to sell the stock at $70 when it is trading at $72. The option expires worthless, and you keep the $200 premium as a profit, excluding commissions.

In the 30 days that your uncovered put is open, the price of XYZ drops below the $70 strike price. It’s trading at $50 when the buyer exercises the option to sell shares at the $70 strike price.

You’re obligated to buy the shares at the strike price and your account is debited the required amount of funds from your margin account. You’re credited with 100 shares of XYZ.

Your ultimate loss will depend on the difference between the price where you were required to buy the shares, the $70 strike price, and the price where you can ultimately sell them.

If you sell the shares at the current market price of $50, your loss would be $1,800, excluding commissions and interest charged:

Proceeds: ($50 market price × 100 shares) + $200 premium = $5,200

Cost: $70 strike price × 100 shares = $7,000

Net loss: $5,200 proceeds − $7,000 cost = - $1,800

Unlike uncovered calls, where your potential loss is unlimited, the maximum loss when selling an uncovered put is the total price you paid when the option was exercised less the premium you received for selling. The potential loss when selling uncovered puts may be substantial but is limited, since the stock price can’t fall below $0.