Naked position

A naked position in the futures market simply means a long or short position in any futures contract without having any position in the underlying asset. Nothing on the other side cushions it: if the price moves the wrong way, the whole loss lands on the trader.

This is the position of the trader (speculator). The workbook says traders take positions based on their expectations without any position in the underlying cash market, and "either take naked positions or spread positions". A naked long is taken when the trader expects a rise; a naked short when he expects a fall.

Naked positions are not a fault in the system. The workbook argues the opposite: hedgers need someone to take the other side, and traders who take naked positions supply that depth. Without them, hedgers may not be able to hedge at all.

Naked versus spread. A spread position consists of two opposite positions — one long, one short — either in two contracts with the same maturity on different products (an inter-commodity or inter-product spread) or in two contracts with different maturities on the same product (a calendar spread). At present only calendar spreads are available for trading in the equity derivatives segment. Because a spread is a combination of two opposite positions, it is hedged to a large extent and treated as a conservatively speculative position. A naked position has no such offset.

How spreads turn naked. A calendar spread is always computed with respect to the near month series. It becomes a naked (open) position when the near month contract expires or either leg of the spread is closed.

Arbitrageurs and naked legs. Arbitrageurs normally lock in profits rather than trade naked. But if one leg of an arbitrage executes and the other does not — because a leg is illiquid, or there is a lag — the arbitrageur is left with naked exposure. The workbook makes the same point about put-call parity arbitrage in Chapter 5.

Naked options. In options strategies the workbook describes the risk in a naked short call as unlimited if prices rise, which is why a bear call spread buys a higher strike call to cap it.

Counting naked and spread positions — the workbook's case (Chapter 3). Mr. A holds:

Spreads are counted from the near month. The 3 short near-month contracts pair off first with the 2 long two-month contracts, then with 1 of the long three-month contracts:

Spreads between month 1 and month 2 = 2
Spreads between month 1 and month 3 = 1
Remaining three-month longs         = 3 − 1 = 2  → naked

What "naked" costs (illustrative numbers). A trader goes naked long one Sensex futures contract at 61,000; the workbook gives the Sensex futures contract size as 20.

Index settles at 61,500:  (61,500 − 61,000) × 20 = +Rs 10,000
Index settles at 60,400:  (60,400 − 61,000) × 20 = −Rs 12,000

Now suppose instead he held a calendar spread — short near month at 61,000, long next month at 61,250 — and the whole market fell 600 points with the gap between the months unchanged:

Near-month short: (61,000 − 60,400) × 20 = +Rs 12,000
Next-month long:  (60,650 − 61,250) × 20 = −Rs 12,000
Net                                       =      Rs 0

The spread lost nothing on the direction of the market. The moment the near month expires, though, the long next-month leg stands alone — naked — and every further point is his to gain or lose.

Chapter 3, section 3.4, defines naked and calendar spread positions; section 3.9 explains why traders take naked positions, how spreads are counted from the near month, and how a spread becomes naked. Chapter 3's sample questions ask whether the far leg becomes a regular open position when the near leg expires (it does) and whether a calendar spread attracts lower margin than two independent legs. Chapter 5 uses naked short calls and naked arbitrage legs, and Chapter 7, section 7.10, records SEBI's removal of calendar spread benefits on the expiry day.

• Naked means no position in the underlying (or no offsetting contract) — not "without margin".
• A calendar spread becomes naked when the near month expires or either leg is closed. It does not wait for the far month.
• Spreads are computed with respect to the near month series. Leftover far-month contracts are naked.
• Traders take naked positions; arbitrageurs generally lock in profits. An arbitrageur becomes naked only when a leg fails to execute.
• Only calendar spreads are available in the equity derivatives segment; inter-commodity spreads are a commodity-segment feature.
• Naked positions are not bad for the market — the workbook credits traders with providing the depth hedgers need.