Selling Naked Calls
Let’s begin by examining the outright trade. Selling naked calls is the highest risk options trade that exists, and most investors will never engage in this trade. It requires a margin account and carries a risk similar to shorting shares of stock. However, the profit potential is not the same as shorting stock.
Consider selling calls with a $50 strike price trading for two dollars, which equals $200 of actual cash exchanged when selling this option. The maximum profit you can make when selling an option is the amount you sold it for. In this case, with significant risk to the upside if the stock moves higher, the potential gain is relatively limited at $200. This naked call does not involve any other options or stock positions.
Understanding the basics of selling naked options is crucial when considering more sophisticated strategies since adding different pieces can dramatically change the risk profile. So, that’s selling naked calls.
Selling Naked Puts
Selling naked puts involves selling a put option on margin without holding the cash to buy shares or any stock position. Just like the call side, the potential gain is limited – in this case, $200 from selling the $50 strike for $2. As long as the stock stays above $50, the maximum gain of $200 can be received without any obligation to buy shares or repurchase the option contract.
The maximum risk is substantial. While the previous example’s risk was similar to shorting stock, this case is akin to buying stock. With a break-even point at $48, below that, you are effectively long shares of stock and face the associated risk profile.
It’s important to note that most options are not held until expiration. A myth exists that the majority of options expire worthless, with figures like 70%, 80%, or 90% being cited. This misconception may lead investors to think that selling options is a profitable strategy most of the time, but that is simply not true.
The majority of options are closed out before expiration, with a sell-to-open transaction followed by a buy-to-close transaction. The actual profit or loss of these trades cannot be determined. The remaining options that are held through expiration mostly expire worthless because there’s no value left in them. This myth ignores the 70 to 75 percent of all open contracts closed prior to reaching expiration and only focuses on the remainder, creating an inaccurate narrative. Therefore, if you’re thinking about selling options, this misconception should not be your motivation.