Introduction

Before diving into the intricacies of option sensitivity measures, it’s crucial to comprehend the inherent risks associated with both naked and covered option positions. These risks lay the foundation for understanding the significance of sensitivity measures like delta, gamma, vega, and theta in managing these positions effectively.

Naked Option Positions

Naked option positions, also known as uncovered positions, involve selling or buying options without holding an offsetting position in the underlying asset. These positions can carry substantial risks.

Risk #1: Unlimited Loss Potential

• Explanation: When you sell a naked call option, your potential loss is theoretically unlimited. If the underlying asset’s price rises significantly, you may have to buy it at a higher price to fulfill the call option’s obligation. This exposes you to substantial losses.

• Example: Suppose you sell a naked call option on Company XYZ with a strike price of USD 50. If XYZ’s stock price soars to USD 100, you must purchase the stock at USD 100 to cover the option, incurring a USD 50 loss per share.

Risk #2: Limited Profit Potential

• Explanation: In naked put options, your profit potential is limited to the premium received when selling the option. If the market moves against your position, your profit may be eroded or wiped out entirely.

• Example: You sell a naked put option on XYZ with a strike price of USD 50 and receive a premium of USD 5. Your maximum profit is USD 5, but if the stock price falls significantly below USD 50, your potential losses can exceed this profit.

Covered Option Positions

In contrast, covered option positions involve holding an offsetting position in the underlying asset. These positions offer a degree of risk mitigation.

Risk #1: Limited Profit Potential

• Explanation: Covered call options limit your profit potential. When you write a covered call, you agree to sell the underlying asset at a specified strike price. If the asset’s price exceeds the strike price, you’ll miss out on additional profits.

• Example: You own 100 shares of XYZ at USD 50 per share and write a covered call with a strike price of USD 55. If XYZ’s stock price rises to USD 60, you’ll sell it at USD 55, missing out on the potential profit beyond USD 55.

Risk #2: Limited Downside Protection

• Explanation: While covered put options provide some downside protection by allowing you to sell the underlying asset at a specified strike price, they may not fully mitigate losses if the asset’s price plummets.

• Example: You own 100 shares of XYZ at USD 50 per share and write a covered put with a strike price of USD 45. If XYZ’s stock price falls to USD 40, you can sell it at USD 45, but you’ll still incur a USD 5 loss per share.