Whenever you sell (short) a call or put by itself, it is called a “naked” position since there are no other assets hedging (protecting) it. Whenever you short an option, you receive cash in exchange for accepting some type of obligation. If you sell a call option, you have the obligation to sell shares of stock at a fixed price. (The long position has the right, not the obligation) to buy shares at a fixed price.) The risk of the naked call is that you may have to buy shares in the open market and deliver them to the long position and there’s no limit as to how high those shares may be trading.
For example, assume you sell a $50 call for $2, which means you will receive $200 for each contract you sell. That’s the maximum amount of money you will ever make from that position. However, let’s assume the stock is trading for $60 at expiration. The long position may wish to exercise, which means you would have to buy shares for $60 and immediately sell them for $50 thus taking a $10 loss. Of course, this $10 loss is offset by the $2 credit you received from selling the call and you’d be left with an $8 overall loss, or $800 per contract.
You could also choose to buy back the short call at expiration but you’d find that it is trading for the $10 intrinsic value, which still leaves you with an $8 overall loss. Whether the long position exercises or you decide to close out the position will lead to the same loss.
For a put option, the risks are the opposite. If you sell a put, you have the potential obligation to buy shares of stock for a fixed price. The risk is that the shares may be trading for much less. For instance, assume you sell a $50 put for $2. Just as with the calls, you’d receive $200 per contract and that’s the most money you could ever make. But let’s assume the stock falls to $40 at expiration. The long put may wish to exercise and sell you the shares for $50. You would receive shares worth $40 but pay $50 thus leaving you with a $10 loss, or $8 loss after accounting for the $2 initial credit. Sure, it’s possible that the shares could rebound at a later date thereby netting you an overall profit – but it could also fall thus increasing the size of your loss. So whether you decide to keep the shares is a decision the trader must make.
The purpose of selling naked calls and puts is usually for pure speculation. Traders who engage in this type of trading are seeking profit based on short-term outlooks. The lure of the strategy is that it appears to be “easy money.” There’s nothing to buy and, in fact, you receive cash up front. But remember there is an obligation attached to that easy money and that obligation can turn out to be expensive as outlined above.
Some investors will short puts as a way to acquire stock at a reduced price. For instance, if you write a $50 put for $3 and are assigned, your effective purchase price is $47 per share.