Also known as an uncovered writer, a naked writer is the seller of an investment option who does not have enough financial resources to actually buy the asset that is being sold. This type of situation sometimes arises when the seller is attempting to sell an options contract that is based on an asset that he or she does not actually own. The strategy is based on the potential for the naked writer to sell the option at a price that is high enough to actually acquire the asset from the owner, then collect that price from the buyer. When successful, the naked writer is able to make a profit from the set of transactions without actually dealing with the expenses of ownership.
Dealing with a naked writer is considered a risky venture. For the buyer who is looking to acquire an options contract from the writer, there is the chance that the deal will fall through before the contract can be purchased from the actual owner and then resold at the price agreed upon between the buyer and the writer. The naked writer also takes on a great deal of risk, in that the buyer could decide to forfeit on the purchase of the contract, which in turn would leave the writer without the resources to honor the commitment to buy the contract from the owner. The owner of the contract also takes on some degree of risk when dealing with a naked writer, since there is the potential of losing money as the result of the writer defaulting on the deal.
The options contracts taken on by a naked writer may be structured as call contracts or put contracts. Since the writer is left with no real ability to hedge on the opportunity, this means defining the terms of the options contracts is very important. Unless the writer is convinced that the underlying asset will perform in a certain manner and that the buyer of the contract will be able to follow through when and if the right to buy or sell is exercised, choosing to go with this type of arrangement can be extremely risky for everyone involved.
While there is a great deal of risk associated with a naked contract obtained through a naked writer, there is also a considerable potential for earning a great deal from the arrangement. Under the best of circumstances, the underlying asset increases in value to an extent that is greater than anyone predicted. When this occurs, the original owner will see the contract exercised by the expiration date, hopefully earning a small return. The writer also earns a profit after paying the owner, since the sale price for the contract was sufficient to generate more revenue than needed to complete the initial commitment to the owner. The buyer also benefits by acquiring an asset that exceeded all expectations, making it possible to then sell that asset for a considerable profit.