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What is an Uncovered Option?

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  • Written By: Malcolm Tatum
  • Edited By: Bronwyn Harris
  • Last Modified Date: 29 November 2016
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    Conjecture Corporation
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Uncovered options are options that are not backed by another position. Sometimes referred to as a naked option, it is possible for the investor to sell the uncovered option along with the right to purchase the underlying investment for a specified strike price. This is in spite of the fact that the investor does not have control of the underlying investment. In the event that the buyer chooses to exercise his or her right to purchase the underlying investment, then the seller will have to buy the underlying asset and sell it according to the terms outlined in the sale of the uncovered call option.

There is an element of risk involved with this type of investment strategy. The hope is that in the event that the buyer chooses to purchase the underlying investment, the seller will be able to acquire the investment at a price that is lower than the rate quoted to the buyer. When this is the case, it is possible to make a profit from the transaction. In order to maximize the chances for this scenario, it is important to research the performance of the underlying investment thoroughly, so that the pricing quoted as part of the uncovered option will cover all costs of acquisition.

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Unfortunately, the uncovered option can just as easily result in a loss. This is likely to occur when the seller does not investigate the status of the underlying investment properly, and offers a lower price to the purchaser of the uncovered option. A loss can also take place when the call option associated with the underlying investment shifts due to unforeseen factors, such as political changes or unexpected weather conditions. When the shift creates a higher demand for the investment, the market price will exceed the strike price, requiring more of a cash outlay to secure control of the investment.

In spite of the risks involved, the uncovered option is a common investment strategy for many individual and institutional investors. The method produces a return often enough for the uncovered option to remain a viable strategy in many markets. However, the uncovered option is not recommended for the novice investor, since evaluating the chances for success require a higher level of knowledge and experience with the process of investing.

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