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Naked Options Expose You To Risk

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By 06.08.2012

As investors become more educated and savvy, they look for new and exciting ways to trade the markets. This often leads investors to seek out the concept of selling naked options.

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What does it mean to trade options naked? It doesn't mean they are trading from a European beach somewhere getting a line-free tan, but rather, the trader is selling options without having a position in the underlying instrument. For example, if one is writing naked calls, they are selling calls without owning the underlying stock. If they did own the stock, the position is deemed to be clothed or "covered."

The concept of selling naked options is a topic for advanced traders. As with any advanced topic, a short discussion such as this cannot cover every possible aspect of profit potential, risk control and money management. This article is designed to be an introduction to the topic and will attempt to shed some light on the riskiness of these trading setups. This type of trading should only be attempted by advanced traders.

Naked Calls

A naked call position is usually taken when the investor expects the stock price to be trading below the option strike price at expiration. It is important to note that the maximum possible gain is the amount of premium collected when the option is sold. Maximum gain is achieved when the option is held through expiration and the option expires worthless.

A call allows the owner of the call to purchase the stock at a predetermined price (the strike price) on or before a predetermined date (the expiration). If you sell the call without owning the underlying stock and the call is exercised by the buyer, you will be left with a short position in the stock.

When writing naked calls, the risk is truly unlimited, and this is where the average investor generally gets in trouble when selling naked options. Most options seem to expire worthless; therefore, the trader may have more winning trades than losers. But with the unbalanced risk versus reward, a single bad trade can wipe out an entire year's gain (or more). Sound money management and risk control are critical to success when trading this way.

Controlling Risk

The call writer does have some risk-control strategies available. The easiest is to simply cover the position by either buying the offsetting option or, alternatively, the underlying stock. Obviously, if the underlying stock is purchased, the position is no longer naked, and it does incur additional risk parameters. Some traders will incorporate additional risk controls, but these examples require a thorough knowledge of options trading and go beyond the scope of this article.

Generally, writing naked options is best done in months that are closer to expiring rather than later. Time decay (theta) is one of your best friends in this type of trade, as the closer the option gets to expiration, the faster the theta will erode the premium of the option. While it won't change the fact that this trade has unlimited risk, choosing your strike prices wisely can alter your risk exposure. The farther away you are from where the current market is trading, the more the market has to move in order to make that call worth something at expiration.

Example 1:

Let's consider stock X for an example of a naked call write. The hypothetical trade mentioned below would be considered by a trader who expected the stock to move lower for the next few months or that the trend would trade sideways. For the sake of simplicity, let's assume X shares are trading at approximately $20 per share at the time of the trade and that the May 22.50 calls were trading at $1. A naked call write would be established by selling the May 22.50 naked (the trader has no position in X stock), bringing in $100 in premium per option sold.

If X stock is below 22.50 at the May expiration, this option will expire worthless and we will keep the $100 premium for each option sold. If it is higher, the option will be exercised and will have to deliver X stock at $22.50 per share. Applying the $1 received for the option against this, the trader's cost basis is short X from $21.50 per share, making the investor's risk the difference between wherever X is trading above $21.50. You can see that makes the maximum risk an unknown. This is why understanding risk management and money management are critical to successfully trading naked calls. Here is a chart of what that would look like:

Source: OptionStar 

(Note: It is important to note that the right part of the chart above showing the risk of loss would extend indefinitely as the stock price continues to climb.)

Because naked call writing is an unlimited-risk proposition, many brokerage firms will require you to have a large amount of capital or high-net worth in addition to a great deal of experience before they will let you make these types of trades. This will be outlined in their options agreement. Once you are approved for trading naked calls, you will also need to familiarise yourself with your firm's margin requirements for your positions. This can vary widely from firm to firm, and if you are trading at a firm that does not specialise in options trading, you may find the margin requirements unreasonable.

Naked Puts

A naked put is a position in which the investor writes a put option and has no position in the underlying stock. Risk exposure is the primary difference between this position and a naked call.

A naked put is used when the investor expects the stock to be trading above the strike price at expiration. As in the naked call position, the potential for profit is limited to the amount of premium received. The investor can make the most if the stock is trading above the strike price at expiration and expires worthless. If this occurs, the trader will keep the entire premium.

While this type of trade is often referred to as having unlimited risk, this is not actually the case. The risk in the naked put is slightly different than that of the naked call in that the trader could lose the most if the stock went to zero. That is still a significant risk when compared to the potential reward. And unlike the naked call, if the put is exercised against you, you will receive the stock (as opposed to receiving a short position in the stock, as is the case of the naked call). This would allow you to simply hold the stock as part of your possible exit strategies.

Example 2:

As an example of writing naked puts, we'll consider the hypothetic stock Y. Let's assume that today is March 1 and that the Y is trading at $45 per share. For the sake of simplicity, let's also assume that the May 44 puts are at $1. If we sell a May 44 put, we will receive $100 in premium for each put sold. If Y is trading above $44 per share at expiration, the put will expire worthless and we will achieve our maximum potential profit of $100 per option sold. However, if Y is below this price at expiration, we can expect Y to be assigned to us, 100 shares for each option sold, at a price of $44. Our cost basis is $43 per share ($44 less the premium received), so that is where our losses would begin.

Source: OptionStar

Contrary to the naked call example, we have a maximum loss on this trade of $4,300 per option sold (100 shares of Y x $43 cost basis). This would only be if the stock (or ETF in this case) went to zero (unlikely in an index ETF, but very possible with an individual stock).

Generally, brokerage requirements will be a little more accommodating with naked puts than with naked calls. The primary reason for this is that if the put is exercised you will be receiving the stock (as opposed to a short stock position, as in the naked call). This makes the maximum risk exposure the value of that stock position less the premium received for the option.

The Bottom Line

Trading naked options can be attractive when considering the number of potential winning trades versus losing trades. However, do not be taken in by the lure of easy money, because there is no such thing. There is a tremendous amount of risk exposure when trading in this manner, and the risk often outweighs the reward. Certainly, there is potential for profit in naked options and there are many successful traders doing it. But make sure you have a sound money management strategy and a thorough knowledge of the risks before you consider writing naked options. If you are new to options trading or you are a smaller trader, you should probably stay away from naked options until you have gained experience and capitalisation.

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