Uncovered Option
Candlefocus EditorThe main risk associated with uncovered options is the unlimited liability that can occur. If the option was exercised, the buyer would pay the full market value of the security, not just the option premium. This means that, if the underlying asset rises in value, the option writer could be liable for a much greater amount than the premium they received for selling the option in the first place.
Moreover, in the case of an uncovered option, the writer does not have the security available to deliver to the buyer of the option. This means that, should the buyer of the option decide to exercise their option and go through with the transaction, the writer would be required to purchase the security in order to deliver it to the buyer. This adds additional risk in that the writer could incur losses from: a) the cost of purchasing the security itself, b) the cost of acquiring it in the open market and c) potential further losses should the security be purchased at a price higher than that of the prevailing options price.
Additionally, since the option is uncovered, the writer will not be able to benefit from any decrease in the price of the underlying security that may occur during the period between selling the option and the option's expiration date. To the contrary, the writer will face the full brunt of any price increase that may develop over the same period of time.
For this reason, the sale of uncovered options should only be made by experienced investors who are willing to take on the large risk associated with it. It is also important to note that regulators generally prohibit the sale of uncovered options unless the investor has large positions in the same underlying security, in order to protect retail investors from taking on too much risk.
In summary, uncovered options are a high-risk market security where the writer of the option does not own the underlying asset. The risk is unlimited and may be much greater than the premium received, as the writer may need to purchase the underlying security at any time and may even incur a loss in doing so. Therefore, such options should only be sold by experienced investors.