There are two sides to every options trade since there is always a buyer and a seller in every market transaction. On options trades, the seller is said to be writing an option, and from the writer’s perspective, the options contract can be covered or naked.

Covered calls and covered puts are written if the seller of the option actually owns the underlying securities. With a naked option, the writer, or seller, does not own the underlying security and the risk can be unlimited.

Consider options in Apple (Nasdaq: AAPL). An investor buys a call contract if they expect the shares of Apple to move higher. The seller of the call contract would believe that Apple will fall.

At expiration, if the price of Apple is above the strike price of the option, then the buyer can exercise the option and buy the shares of Apple at the strike price. The seller of the option is obligated to deliver those shares. If the seller of that contract does not own shares of Apple, they have written a naked call option and will be forced to buy shares at the market price, resulting in a loss.

The profit for the writer if Apple falls is limited to the premium they collected for the option sale, but they can face significant losses if Apple moves up before expiration. In fact, the risk with this strategy is theoretically unlimited.

Traders buying put options expect prices to fall. The seller of the put option most likely believes that prices will rise. Naked put option sellers will lose on the trade if the underlying security declines in price.

Their risk is limited because prices can only fall to zero, so the maximum loss is equal to the strike price while the maximum gain is limited to the premium collected when the trade is initiated. Naked put selling generally involves taking a large risk in the hope of making a small profit on any individual trade.

How traders use it
Most option contracts expire worthless. This could be due to the fact that many options buyers use options strategies as insurance against a sudden market crash. This can involve buying deep out-of-the-money puts, and the buyers expect most options to expire worthless since crashes should occur infrequently. The infrequent winning trade for these put buyers will be very large, but a number of losing trades will be completed with very small losses.

Naked option writers are taking advantage of the fact that most options contracts will expire with no value and are selling option contracts they believe have a small chance of being exercised. These traders believe that selling deep out-of-the-money options seems like a low-risk way to collect small premiums without having to deliver the shares at expiration.

If a trader is able to do a number of these small trades successfully, it could add up to significant profits over time. However, occasional large losses could erase the small profits accumulated over many trades.

Why it matters to traders
Naked options offer potentially large profits over time. Since most options do expire worthless there are a number of relatively low-risk strategies that can be applied to sell naked options. But if a large market move occurs suddenly, then the options seller could face very large losses. In a market crash, put sellers would suffer and could see the profits from thousands of small trades lost in minutes.

Success in options selling could be very dependent on when the trader begins selling naked options. If they enjoy a long bull market before any put contracts are exercised, the large loss could be paid from accumulated profits. If the market crashes shortly after they begin to follow this trading strategy, the large loss could be catastrophic.

This article originally appeared on ProfitableTrading.com:
Naked Options: Is the Reward Worth the Risk?

[Note: My colleague Amber Hestla-Barnhart of ProfitableTrading.com has just released a report that answers ten commonly-asked questions about boosting income with options. If you’d like learn more, click here.]