Selling naked options – either calls or puts – is an essential aspect of trading that most investors may find intimidating due to the perceived risk involved. While the level of risk can indeed be high, understanding the fundamentals and implementing the right strategies can enable traders to navigate this field confidently. This article aims to provide a comprehensive understanding of selling naked calls and puts, dispel common myths, and suggest beneficial strategies for investors.
Understanding Naked Calls
Selling naked calls is not for every investor, primarily due to its high-risk nature, akin to shorting shares of stock. To undertake this, you need to have a margin account. It’s worth noting that the risk-to-reward ratio is skewed; while the downside risk is similar to shorting stock, the profit potential is not.
For instance, let’s consider a $50 strike price call trading for two dollars. This translates into an actual cash transaction of $200 when selling this option. Remember, the maximum profit you can make from selling an option is what you initially sold it for. Therefore, the limited potential gain here is $200. In this scenario, you’re trading a naked call, meaning you have no other position – neither an options position nor a stock one.
Grasping the basics of naked calls is vital because it sets the foundation for more sophisticated strategies. By adding different pieces to the basic setup, you can dramatically alter the risk profile.
Unpacking Naked Puts
Selling naked puts implies that you lack the cash to buy shares and are seeking to profit from selling the put option, once again on margin. The mechanics here mirror those of selling naked calls – they are essentially two sides of the same coin.
If we consider the same $50 strike sold for $2 or $200, the most we can gain is $200. We achieve this maximum gain as long as the stock remains above $50, and we are not obligated to purchase shares or buy back the option contract. However, if the stock price falls below $48, we are effectively long shares of stock, meaning our risk profile mirrors that of a stock buyer.
Dispelling the Expiration Myth
There’s a common misconception in the options industry: Most options expire worthless. Various figures – 70%, 80%, 90% – are often bandied about, leading investors to think that selling options is a surefire strategy. This is, however, a myth.
In reality, the majority of options never reach expiration and are closed out beforehand. Therefore, the actual profit or loss from an option cannot be determined solely based on its expiration status. When you sell a call or put, you open the transaction on the sell side and usually close it out before it reaches expiration.
Of the remaining options held through expiration, the majority may indeed expire worthless. But this fact only accounts for a small segment of all option contracts. Therefore, while it might be true that 70 to 75 percent of all open contracts expire worthless, these figures only represent the small proportion that remains open until expiration, and not the vast majority of options contracts.
If you’re thinking about selling options, it’s crucial not to be swayed by this myth. Selling naked calls and puts is a nuanced strategy that requires a comprehensive understanding of market dynamics and individual risk profiles.
