Define Naked Option:

"In finance, a naked option refers to an options trading strategy in which an investor sells (writes) an options contract without owning or holding a position in the underlying asset."

Explain Naked Option:

What is Naked Option?

There are two types of naked options:

1. Naked Call Option: When an investor sells a call option without owning the underlying asset, it is referred to as a naked call option. By selling the call option, the investor assumes the obligation to sell the underlying asset at the specified strike price if the option is exercised by the buyer. If the price of the underlying asset rises significantly, the investor may be exposed to unlimited risk, as they would have to buy the asset at the prevailing market price to fulfill their obligation.
   
   
2. Naked Put Option: When an investor sells a put option without holding the underlying asset, it is known as a naked put option. By selling the put option, the investor assumes the obligation to buy the underlying asset at the specified strike price if the option is exercised by the buyer. If the price of the underlying asset falls significantly, the investor may be exposed to potential losses, as they would have to purchase the asset at a higher market price to fulfill their obligation.

Naked options are considered high-risk strategies because the investor is exposed to unlimited potential losses if the price of the underlying asset moves against their position. They should only be undertaken by experienced traders who have a thorough understanding of options trading and are willing to bear the associated risks.

It's worth noting that in some jurisdictions, certain requirements and restrictions may apply to naked option trading, such as margin requirements or minimum capital thresholds, to protect both the investor and the overall market stability.

It's important for investors to understand the risks involved in naked options and to have a comprehensive knowledge of options trading strategies.

Example of Naked Option: 

Let's consider an example of a naked call option to illustrate the scenario.

Suppose Company XYZ is currently trading at $100 per share, and you believe that the stock price will remain below $110 in the coming months. You decide to sell a naked call option on Company XYZ with a strike price of $110 and an expiration date in three months. The premium you receive for selling the option is $5 per share.

By selling the naked call option, you are obligated to sell Company XYZ shares at the strike price of $110 if the option is exercised by the buyer. However, since you don't own the shares, you are exposed to potential risk if the stock price rises significantly.

Scenario 1: Stock Price Remains Below the Strike Price

If the stock price of Company XYZ remains below $110 until the option expiration, the call option will expire worthless. As the seller, you get to keep the premium of $5 per share as profit. In this case, you have successfully executed the naked call strategy and generated income without having to deliver any shares.

Scenario 2: Stock Price Rises Above the Strike Price

However, if the stock price of Company XYZ rises above $110 before the option expiration, the buyer of the call option may choose to exercise it. Let's say the stock price rises to $120 per share. The buyer has the right to buy the shares from you at the strike price of $110, even though the market price is higher.

In this scenario, you would need to purchase the shares at the market price of $120 per share to fulfill your obligation to the buyer. As a result, you would incur a loss of $10 per share ($120 market price - $110 strike price). Since each option contract typically represents 100 shares, the total loss would be $1,000 per contract (100 shares x $10 loss).

This example illustrates the risk associated with selling naked call options. If the stock price continues to rise significantly, your losses can be substantial and potentially unlimited. It's important to carefully assess the market conditions, evaluate the potential risks, and have a clear strategy in place before engaging in naked option strategies.

Please note that options trading involves complexities and risks, and this example is for illustrative purposes only.