There are two parties to an option contract – the buyer (holder) and the seller (writer). If you are an option writer, you can be covered or naked.
For example, say you write and sell a call option. This gives the buyer the right to demand shares at a fixed strike price anytime before the option expires. If the option is exercised and you already own the shares as the writer, you are said to be covered.
If, on the other hand, you don’t own the underlying shares and will have to find them should the option get exercised, you are known as a naked writer. The same is true with put options. However, this time the holder has the right to sell you shares at a fixed strike and you have an obligation to buy them.
If you hold the cash needed to pay for them you are known as covered and if you don’t your position is naked. Naked writing is riskier in both cases.
• See Tim Bennett’s video tutorial: What are options and covered warrants?