Naked Option Selling Is A Risky Strategy
For the record, I do not recommend naked option selling. Of all of the techniques, I consider naked options to be the most risky. This is the only advanced strategy that is not automatically paired up with a spot, futures, or other option position to protect you from the risk.
Naked option selling has two handicaps: misinformation and leverage. The first handicap is misinformation. The fictional number of 90 percent of options expiring worthless was rightly dispelled, but it also reduces the level of confidence that can be had in believing in its overall success, particularly when only 30 percent of options actually make it to their expiration dates.
The second handicap is leverage. When initiating a futures contract, doing a spot forex transaction, or purchasing an option, it can be comforting to know that the leverage is on your side. The amount of money you can earn on your positions is vastly superior, in terms of percentage, to the actual amount you have put up. In gold trading a $1 move is equal to $100. It only takes a $54 move to match the necessary futures margin, $5,400. This leverage works against naked option sellers.
If an option seller sells an at-the-money option and collects $1,800, it only takes an $18 move into-the-money, at $100 per $1 move, to eliminate his entire collected premium. If an out-of-the-money option is sold for $800, then it simply takes an $8 move into-the-money against the seller before he gives up all of his profits. Although there is more leeway between the strike price and the cash price when it comes to an out-of-the-money option, it still doesnt take much to eliminate the collected premium.
There are two primary benefits of selling naked options. First, your margin reserves are 50 percent of what it would take when putting on short straddles and strangle positions. A second key benefit is that you know ahead of time what your potential return on investment can be. In Table 13.6 we see that a gold 940 call has the potential to return 34 percent, and in Table 13.7 we see that a gold 960 call has the potential to return 15 percent.
As you sell options further and further out-of-the-money, your overall return diminishes, but the likelihood of you getting that return increases. This is a constant trade-off when it comes to selling naked options. How far can you sell your option contract out-of-the-money before the amount of capital you tie up doesnt justify the unlimited risk you are exposed to and the limited returns you are capable of earning?
Table: Example 1: At-the-Money Option Premium
Gold 940 Call
Margin$5,400
Premium$1,830
Delta.483
Return on investment34%
Table: Example 2: Out-of-the-Money Option Premium
Gold 940 Call
Margin$5,400
Premium$820
Delta.315
Return on investment15%
This is not an easy question to answer. It becomes a personal choice of whether you wish to earn 15 percent or 5 percent. Your technical analysis tools or market opinion will determine how you expect to interact with the market and where you expect it to go. The more aggressive may sell only at-the-money options, and the less aggressive will sell out-of-the-money options. However you approach selling options, do not take it lightly.
Naked Option Wrap-Up
Tackling a naked option is much like tackling a regular futures contract. There is so much exposure to risk that the rewards may not be there. If you sell an at-the-money option you can collect a significant premium, compared to shorting a straddle or a strangle. Selling only one option diminishes your capital commitment to the brokerage firm as well. Nevertheless, with the increased premium comes increased exposure to risk. The exposure to unlimited risk compared to the premium that can be collected makes the sale of an at-the-money option less attractive.
Selling out-of-the-money options can be slightly more attractive. While unlimited risk still looms over the sellers head, time decay and decreased volatility work in favor of the option seller. The key trade-off between selling an at-the-money option versus an out-of-the-money option is the amount of collected premium. Where an at-the-money option premium has a potential return as high as 30 percent or more, an out-of-the-money option may bring in as little as 5 to 7 percent. If the market suddenly moves against an out-of-the-money option seller, the limited rewards5 to 7 percent returnssimply dont justify the exposure to unlimited risk.
If a trader chooses to be a naked option seller, the risk and reward must constantly be weighed. Once the rewards are significantly diminished by the potential risk, a reassessment must be done on how to approach that risk. This may mean either avoiding selling options altogether or making sure you take advantage of the daisy-chain relationship of the spot, options, and futures markets combined for maximum opportunity.
Conclusion
Whether you are selling straddles, strangles, or naked options, you are exposing yourself to a significant amount of risk. Much of this risk can be offset by buying options to counter the risk, but once that is done, we move into more exotic trading of synthetic futures and synthetic futures collars. Purchasing an additional option as protection forces you to use the premium you collected inefficiently, practically eliminating the entire reason you sold the option in the first place.
The smart way to manage your option selling risk is to simply use a stop. Since options do not move at the same speed as the underlying asset, you have an opportunity to exit with a little less sticker shock, as opposed to dealing with slippage in the futures market and the volatile forex market.
This is a style of trading that should not be taken lightly and quite literally is not meant for everyone. Paper trading and demo trading the ideas in this article should not need to be emphasized, but I will point out one more time that selling options involves unlimited risk, and when it comes to trading in futures and commodities you can not only lose your entire investment, but you can also lose much more.
Sell options with both caution and common sense, and you will find yourself tapping into small, but consistent, profit opportunities for the rest of your life. Many successful Commodity Trading Advisors have successfully created practices solely around selling options or establishing straddles and strangles. The trick to being successful at selling options comes from your ability to temper your profit goals. If you are willing to turn your back on the potential of unlimited risk in favor of taking small bite-size chunks from the market, your entire market outlook evolves.
Naked option selling has two handicaps: misinformation and leverage. The first handicap is misinformation. The fictional number of 90 percent of options expiring worthless was rightly dispelled, but it also reduces the level of confidence that can be had in believing in its overall success, particularly when only 30 percent of options actually make it to their expiration dates.
The second handicap is leverage. When initiating a futures contract, doing a spot forex transaction, or purchasing an option, it can be comforting to know that the leverage is on your side. The amount of money you can earn on your positions is vastly superior, in terms of percentage, to the actual amount you have put up. In gold trading a $1 move is equal to $100. It only takes a $54 move to match the necessary futures margin, $5,400. This leverage works against naked option sellers.
If an option seller sells an at-the-money option and collects $1,800, it only takes an $18 move into-the-money, at $100 per $1 move, to eliminate his entire collected premium. If an out-of-the-money option is sold for $800, then it simply takes an $8 move into-the-money against the seller before he gives up all of his profits. Although there is more leeway between the strike price and the cash price when it comes to an out-of-the-money option, it still doesnt take much to eliminate the collected premium.
There are two primary benefits of selling naked options. First, your margin reserves are 50 percent of what it would take when putting on short straddles and strangle positions. A second key benefit is that you know ahead of time what your potential return on investment can be. In Table 13.6 we see that a gold 940 call has the potential to return 34 percent, and in Table 13.7 we see that a gold 960 call has the potential to return 15 percent.
As you sell options further and further out-of-the-money, your overall return diminishes, but the likelihood of you getting that return increases. This is a constant trade-off when it comes to selling naked options. How far can you sell your option contract out-of-the-money before the amount of capital you tie up doesnt justify the unlimited risk you are exposed to and the limited returns you are capable of earning?
Table: Example 1: At-the-Money Option Premium
Gold 940 Call
Margin$5,400
Premium$1,830
Delta.483
Return on investment34%
Table: Example 2: Out-of-the-Money Option Premium
Gold 940 Call
Margin$5,400
Premium$820
Delta.315
Return on investment15%
This is not an easy question to answer. It becomes a personal choice of whether you wish to earn 15 percent or 5 percent. Your technical analysis tools or market opinion will determine how you expect to interact with the market and where you expect it to go. The more aggressive may sell only at-the-money options, and the less aggressive will sell out-of-the-money options. However you approach selling options, do not take it lightly.
Naked Option Wrap-Up
Tackling a naked option is much like tackling a regular futures contract. There is so much exposure to risk that the rewards may not be there. If you sell an at-the-money option you can collect a significant premium, compared to shorting a straddle or a strangle. Selling only one option diminishes your capital commitment to the brokerage firm as well. Nevertheless, with the increased premium comes increased exposure to risk. The exposure to unlimited risk compared to the premium that can be collected makes the sale of an at-the-money option less attractive.
Selling out-of-the-money options can be slightly more attractive. While unlimited risk still looms over the sellers head, time decay and decreased volatility work in favor of the option seller. The key trade-off between selling an at-the-money option versus an out-of-the-money option is the amount of collected premium. Where an at-the-money option premium has a potential return as high as 30 percent or more, an out-of-the-money option may bring in as little as 5 to 7 percent. If the market suddenly moves against an out-of-the-money option seller, the limited rewards5 to 7 percent returnssimply dont justify the exposure to unlimited risk.
If a trader chooses to be a naked option seller, the risk and reward must constantly be weighed. Once the rewards are significantly diminished by the potential risk, a reassessment must be done on how to approach that risk. This may mean either avoiding selling options altogether or making sure you take advantage of the daisy-chain relationship of the spot, options, and futures markets combined for maximum opportunity.
Conclusion
Whether you are selling straddles, strangles, or naked options, you are exposing yourself to a significant amount of risk. Much of this risk can be offset by buying options to counter the risk, but once that is done, we move into more exotic trading of synthetic futures and synthetic futures collars. Purchasing an additional option as protection forces you to use the premium you collected inefficiently, practically eliminating the entire reason you sold the option in the first place.
The smart way to manage your option selling risk is to simply use a stop. Since options do not move at the same speed as the underlying asset, you have an opportunity to exit with a little less sticker shock, as opposed to dealing with slippage in the futures market and the volatile forex market.
This is a style of trading that should not be taken lightly and quite literally is not meant for everyone. Paper trading and demo trading the ideas in this article should not need to be emphasized, but I will point out one more time that selling options involves unlimited risk, and when it comes to trading in futures and commodities you can not only lose your entire investment, but you can also lose much more.
Sell options with both caution and common sense, and you will find yourself tapping into small, but consistent, profit opportunities for the rest of your life. Many successful Commodity Trading Advisors have successfully created practices solely around selling options or establishing straddles and strangles. The trick to being successful at selling options comes from your ability to temper your profit goals. If you are willing to turn your back on the potential of unlimited risk in favor of taking small bite-size chunks from the market, your entire market outlook evolves.
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