Monday, 29 February 2016

NAKED OPTIONS AND RISK

When you anticipate that a stock (or index) will undergo a bullish or bearish price change, there are several (very basic), limited-risk, option strategies that you can adopt. These involve buying option premium.
·         Buy calls or call spreads when bullish.
·         Buy puts or put spreads when bearish.
The more experienced trader may also want to consider selling option premium in order to collect time decay (Theta is one of the Greeks that helps traders measure and manage risk).
·         Sell call spreads when bearish.
·         Sell put spreads when bullish.
·         Sell naked (cash secured) puts when bullish -- but only when you are willing to own shares of the underlying stock.
NOTE: The more sophisticated reader knows that buying a call spread and selling a put spread are equivalent positions (with essentially identical profit and loss parameters) when the underlying asset, strike prices, and expiration are identical.
Likewise, selling a call spread and buying a put spread are equivalent positions. 
Selling naked (unhedged) call options is considered to be too risky for most investors for two very sound reasons:
1.    The sum at risk is theoretically unlimited, and too many inexperienced investors destroy their trading accounts when adopting this strategy. Thus, very few brokers allow their inexperienced traders to sell naked call options. It is just as easy to go broke when selling naked put options, even though most brokers allow their customers to adopt this strategy.
 
2.    Careful, skilled risk management is mandatory. It is very difficult for the novice trader to realize how unprepared he/she is to handle the risk associated with being naked short call options as the price of the underlying asset rises day after day.

Advice: If selling naked options is attractive to you (I shudder), please be certain that you sell an appropriate quantity of option contracts. Unexpected market events occur far more often than statistics predict -- and you must never own a position so large that it can jeopardize your entire brokerage account when one of those events does occur.
P/L Graphs illustrate Ultimate Risk
Buying options: Gains are unlimited whiles losses are limited to the cost of the options bought.
Risk Graphs: Buying calls and buying puts.

Buying spreads: Both profits and losses are limited, but the potential loss is reduced when compared with the strategy of buying options.
Risk Graphs: Buy call spread;  buy put spread.

Selling spreads: Selling call spreads;  selling put spreads.
Naked Options :  Selling naked calls;  selling naked puts.
There are several important discussion points:
·         Buying options offers the largest potential reward. The problem is that investors tend to believe that they can predict when stocks are moving higher or lower. Then they tend to believe that their stock picks will not only move as predicted, but that the price change will be large. That confidence, combined with a lack of understanding about how options work, leads to money-losing trades. Not because the stocks did not move as predicted, but because the traders bought the wrong options at prices that were too high. The game of earning money by buying options ahead of a price change in the stock or index is best left to very experienced traders who have a proven track record of correct predictions.
·         Buying or selling spreads. These strategies provide the best practical chance for traders to earn a profit. However, it it important to avoid buying spreads that are out of the money. My recommendation is to sell out-of-the-money call spreads when bearish and to sell out-of-the-money put spreads when bullish. Why? These trades come with a high probability of success (i.e., earning a profit). Just be careful not to sell spreads where the reward potential is tiny (i.e., do not try to earn $0.10 by selling a 5-point spread).
·         Selling naked options. Unless you want to be assigned an exercise notice and purchase stock at the strike price, selling naked options is a hazardous proposition. Notice that the potential gains are limited while the possible loss is unlimited. Another point worth noting is that the margin requirement for naked option positions is relatively high, and traders with small accounts cannot meet those requirements. 
​​Selling naked options is not a good strategy choice for most option traders. Sure, it may be acceptable for occasional use, but be very careful when choosing the position size.

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