When used in a financial context, the term “naked position” makes reference to a sale made by a trader of an option contract, but the trader does not hold a position in the underlying security – which would offer some protection in the event of a downward shift in price. Sales from a naked position are usually considered extremely risky, in part because it is theoretically possible for this type of sale to bring an unlimited loss! For this reason, many brokerages will not permit traders without significant experience to make this kind of a transaction.
As an example, consider the hypothetical current price of a company to be $10. Suppose a trader sells ten call options with a strike price of $20 for $55 per contract (usually 100 shares). There will usually be a quote, in this case $0.55, so each contract sells for $55 ($0.55 x 100 shares). The option writer in this case is able to collect $550 (($0.55 x 100) x 10), and he or she is allowed to keep that premium – assuming the price closes below the $20 strike price.
But in the event that the company publicizes exciting news about some new products, and the price soars to $45, the option writer with a naked position is in a sudden predicament because he or she does not actually own the shares. The option writer must now purchase the shares for the new price of $45, and sell them to the purchaser of the option at the $20 strike price. This means that the option writer is on the hook for an amount equal to the difference between the market price and the strike price times 1,000 (or the number of shares in 10 option contracts), less the amount received from the sale of the options (($45 – $20) x 1,000) – 550 = $24,450).
Because of the possibility of these kinds of heavy losses, individual traders should take great care when considering the placement of this type of trade.