Undefined Risk refers to the risk that is accompanied with naked options and when your possible max loss is unknown on order entry. This normally refers to a naked call as the underlying equity could possibly go up indefinitely. Naked puts also have undefined risk, however we know that an underlying can only go to zero so we can consider this our max loss.
We are able to define Undefined Risk by the amount of margin that a brokerage firms requires for a naked option. While every brokerage firm is different, this is normally the loss you would see if there was a 2 standard deviation move in the underlying. A 2 standard deviation move will will encompass 95% of all moves in a given time period. For this reason, the broker sees this as your maximum potential loss on a naked option and will hold this amount of capital as margin.
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