Naked Contract: Everything You Need to Know
A naked contract is an unenforceable agreement because it’s made without consideration.3 min read
A naked contract is an unenforceable agreement because it’s made without consideration. Also called a nude contract, a naked contract got its name due to the missing element required for an enforceable contract. In addition to the consideration element, there must also be an offer, acceptance, mutual assent, and legal capacity for all parties in the contract. Particularly, legal capacity is important, as incapacity will render the contract unenforceable and void. Legal incapacity includes any one of the following:
1.Someone under the age of 18
2.Someone under the influence of drugs or alcohol
3.Someone who is imprisoned
4.Someone who is mentally
Contracts Not Requiring Consideration
While most contracts must include consideration as a required element, there are some contracts that don’t require consideration, including sealed instruments, bills of exchange, and promissory notes.
A naked option is an option contract that doesn’t involve ownership of the security involved in the contract; therefore, the purchasing and selling parties don’t actually own the security. A trader who drafts a naked option on a security agrees to sell the stock at a particular price, referred to as the strike price, on or before the expiration date identified in the options contract. The agreement to sell at the strike price is a requirement, regardless of how much money the stock is worth. If the trader himself doesn’t own the stock, the seller will need to obtain the stock and then sell the stock, also referred to as shorting the stock, in order to meet the contractual obligation if the other party exercises the option.
An example of a naked option involves a broker who assumes that the price of a particular stock won’t increase in the following month, but believes that a decline in the price would be astronomical. Let’s assume that the shares are priced at $50 with a $55 strike call and an expiry date of 30 days from the current date. Currently, the stock is selling at $5/share.
The trader then decides to open a naked call by agreeing to sell such calls and obtaining premium payments on the option itself. Now let’s assume that the trader chooses not to buy the stock because he believes as though the option will have no value. Such options provide investors with the ability to profit from the premiums received on the naked options without having to engage in a long or short position. Utilizing this example, the three outcomes of a naked call include the following:
1.The option is carried out, at which point the trader will need to acquire the shares at the current share price and then short the stock at the options price of $50.
2.The shares will remain flat near the $55 per share when the contract has expired; if the stock is at or below the strike price at this time, the trader will not exercise the option. But the will keep the premium that was initially given.
3.The stock falls to a price below the strike price when the naked option expires. For example, assuming that the share price dropped to $30. There won’t be anyone who will want to purchase the strike price of $55 when the stock itself can be purchased for $30. Therefore, the outcome here is similar to option #2 where the option won’t be exercised, but the options seller will keep the premium.
A naked put involves a seller who has a responsibility to purchase the security at the strike price if the option is exercised by or before the expiration date. However, the seller’s risk is reduced since the stock cannot drop below $0. Therefore, while there is no maximum limit on a stock’s value, thereby causing potential significant risk on the part of the person selling the naked call, the seller of the naked put has much less risk since the security cannot go below the $0 mark. While the overall risk is in fact reduced somewhat, there is still potential for greater risk on the part of the naked put seller. Thus, traders usually have certain rules and requirements when it comes to naked option trading. In fact, some brokerage firms might not allow junior-level or inexperienced traders to engage in naked puts or options.
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