Naked Calls & Puts – Key Points About Selling Options Part 3

Naked Calls & Puts – Key Points About Selling Options Part 3

 

Naked Calls & Puts – Key Points About Selling Options (Part 3)

 

Selling Naked Calls

First, just looking at the outright trade. Now selling naked calls, the first thing I’ll say about this is that most investors will never do this trade. It’s the highest risk options trade that exists. It would be required to trade this in a margin account and it’s very similar from a risk perspective to shorting shares of stock. Some of the others might think well, I do short stock. So maybe I would consider this. Well, it’s different.

Your risk to the downside is similar to that, but the profit potential is not similar to shorting stock. In the case of selling calls here, we have the $50 strike price called trading for two dollars. That equals to hundred dollars of actual cash that changes hands when selling this option. The most you can make when you sell an option is what you sold it for. So, as you can see with the significant amount of risk to the upside of the stock moving higher there is a relatively limited possible gain here of $200. And this is a naked call. No other position, you have no other options position, no stock position at all.

This is just the outright position of naked calls. It’s important to understand this when you’re looking at doing other more sophisticated strategies because it all starts from here. And then when you add different pieces to it, you change the risk profile dramatically. But understanding the most basic level, and that’s selling the naked options, is where to start. So that’s selling naked calls.

 

Selling Naked Puts

What selling naked puts means is that you actually don’t have the cash to buy shares and you’re trying to sell a naked put, again on margin, to profit just from selling the put option. You don’t have any other position you don’t have any stock position. So in this case, it’s just like the call side, they’re exactly the same. The $50 strike we sold for $2 or $200 most we can make is that amount – $200, so very limited gain. As long as the stock stays above $50 and we are not obligated to do anything, with respect to buying shares, or we don’t have to buy back the option contract for any amount; that maximum gain will be received in the amount of $200. Maximum risk is substantial.

On the previous example the risk was similar to shorting stock. In this case, it’s exactly like buying stock. We have a little bit of a buffer from the $50 strike and a break-even of $48, but below $48, we are effectively long shares of stock and have a risk profile associated with that. Now, when it comes to reaching expiration and holding positions, one thing I want to point out upfront is most options are not held until expiration. There is a myth that exists that most options expire worthless.

I’ve heard various numbers, 70%, 80%, 90% of all options expire worthless. And that’s what sometimes leads investors to think, I’m just going to sell options because it works almost every time and it’s a myth. It simply isn’t true, the vast majority of options never reach expiration and are closed out. So, if you sell a call or so I’ll put, what that means is you’re opening the transaction on the sell side and then following that up with a buy to close transaction exiting before ever reaching expiration. In that case the option profit or loss really cannot be determined. The industry doesn’t know how profitable that trade was.

All the industry knows is that the trade is closed. The remaining options that are held through expiration, of those the vast majority maybe 70, 80, or 90 percent expire worthless, and that makes sense because there’s no value left in them. So, the ones that are actually held all the way through expiration couldn’t be traded out of, so of that much smaller segments the majority of them expire worthless. And that’s where that myth comes from, the myth ignores the 70 to 75 percent of all open contracts that are closed prior to reaching expiration and only focuses on the remainder and it really tells an inaccurate story. So, if you’re thinking about selling options, that should not be a motivation for doing so.