An option gives the holder of the option the right to buy or sell an asset, but the holder does not have to exercise the option. Unlikely in futures or forward contract, where the two parties are committed to some action, options are fundamentally different. 

Options are classified into call options and put options. A call option gives the holder the right to buy an asset by a certain date (maturity date) for a certain price. A put option gives the holder the right to sell an asset by a certain data for a certain price. 

In every option contract there are two sides. On one side is the investor who has bought the option (long position) and on the other side is the investor, who has sold the option, i.e. has written the option (short position). The investor, who buys the option, gives to the writer of the option cash or borrows money using a margin account. The initial margin, which is the amount that initiates the contract, is typically 50% of the value of the underlying asset and the maintenance margin, which guarantees that the account will always remain positive, is typically the 25% of the value of the underlying asset. 

A naked call option is an option that in not combined with an offsetting position in the underlying asset and the option writer does not own the stock. Naked call option is highly risky because if the calls are exercised the writer has to buy the underlying asset on the spot market at a higher price in order to deliver it. This strategy is used by an investor who is interested in buying a stock below its market price.  

The initial margin required by the Chicago Board Options Exchange (CBOE) for a written naked call option is greatest of (1) the 100% of the proceeds of the sale plus a 20% of the underlying asset less the amount by which the option is out of the money or (2) the 100% of the proceeds plus a 10% of the underlying asset’s price. 

Example:

We assume that an investor writes three naked called options, where option price is $8, strike price is $42, and exercise price is $39. The option is $3out of the money, i.e. the strike price is greater than the exercise price by $3.  

To decide on the initial margin, we calculate as follows: 

(1)      300 x [8+ (20% x 39) – 3] = 300 x ( 8 +7.8 – 3) = $3,840

(2)      300 x [8+ (10% x 39)] = 300 x (8 + 3.9) = $3,570 

The initial margin requirement for this naked call option is therefore $3,840. 

There has been a lot of discussion as to whether naked short selling is legal. Although, advocates of naked short selling assert that is not necessarily a violation of the federal securities laws, still it is illegal if it causes a decline in the market prices. Typically, traders borrow a security before they sell it. Therefore, if a trader sells a stock short, without having borrowed the security, or without determining that it can be borrowed, then this traded is engaged in illegal naked short selling.

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Article Source:http://www.articlesbase.com/investing-articles/a-look-at-naked-short-selling-of-stock-854190.html

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