DON’T MAKE THIS TRADE: Why Trades Like THIS Can Blow Up Your Entire Portfolio

On Friday, one writer suggested that traders "could" sell short straddles (a naked call and a naked put) against Apple to "take a bite" out of volatility. Our advice: Do not do this. Don't take our word for it — Ask Melvin Capital why you shouldn't take on infinite risk trading strategies.

Justin Nugent

This article was last updated on 09/30/2022.

Naked options, short straddle, naked straddle, infinite risk options trade

We aren’t here to bash anyone — but for education’s sake: Let’s talk about everything that’s wrong with this naked options trade.

A Trading Mistake You Can’t Afford to Make: Short Straddle in Apple (AAPL)

This is one Apple trade where the juice isn’t worth the squeeze. Source: Investors.com

The trade above, published on Friday, September 30th, advises readers that they could sell a short straddle — two naked at-the-money options against Apple — expiring October 21st, in order to “take a bite out of volatility.” The trade provides a maximum credit of $11.00 if Apple trades within a range of $130 to $152 by the 21st. More importantly, the trade provides no safety net, and thus infinite risk.

That’s the key detail that the article forgets to mention: If this stock goes too far south (or north, for that matter), you could be margin called, have your portfolio liquidated, or even worse: go into the negative

What’s the Difference Between Infinite Risk and Defined Risk?

This isn’t a scare tactic. We all know options carry risk. Even long options can quickly fluctuate in value amid volatile trading. However, long options carry defined risk. That means if you buy:

  • A call
  • A put
  • A vertical call spread
  • A vertical put spread
  • A calendar debit spread
  • A diagonal debit spread

You can’t lose any more than you’re spending on the initial trade. You spent $100? You can only lose a max of $100. And there are short option strategies that also have defined risk. Option strategies that we use all the time at Market Rebellion, like short iron condors and credit spreads. At most brokerages, these trading strategies require a collateral in order to be opened, and that collateral is the max you can lose if the trade goes completely against you. These are all examples of defined risk

However, when you open up a naked option strategy, like a:

  • Short straddle
  • Short strangle
  • Short call

You’re taking on infinite risk. If you sell a call (which short strangles and short straddles both do), you’re obligated to deliver 100 shares per contract at the strike price of the call to the buyer of the call on the specified expiration date. If the call option expires out-of-the-money, it’s no big deal. But if the call expires in the money, you’re on the hook. Remember: Stock prices can theoretically rise endlessly — something that GME short sellers had to experience first hand

In the trade example above, where readers are advised to sell a $141 call and a $141 put in Apple, there are three possible outcomes.

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The 1st Outcome: Apple Shares Trade Sideways, Remaining in the Range.

This is the intended outcome of the trade. If shares of Apple expire at $141, both the call and the put will expire worthless — bad for the buyer, great for you. You’ll bank a max of $11.00 ($1,100) per straddle sold, a little less the further you stray from the middle, breaking even at $130 or $152. But even if this did work out for you, it’s still a bad trade. There are many other premium collection strategies that don’t require you to take on infinite risk to take on an upfront credit. (More on that below.)

The 2nd Outcome: Apple Shares Plummet — Taking Your Portfolio With It

A little food for thought: 18 days ago, on September 12th, Apple shares closed at $163.43. Today, shares of Apple closed at $138.20. That means over the last 18 days, Apple lost 15.4% of its value. If the trend continues, and Apple loses another 15.4% over the coming 18 days (There are 21 days until expiration of the option), Apple will be trading at $116.92. If that happens, this trade will be worth -$18.58 per contract — a loss of $1,858 dollars. 

How? 

The short call — the $141 strike call you sold — expires worthless, netting you a max credit of $5.50 per contract. However, you sold a put option at the $141 strike. That means you’re promising to buy 100 shares of Apple per contract at $141 per share. With a new share price of $116.92, you’re taking a loss of $24.08 per contract. When it all settles out, you’re at a loss of $1,858 dollars — more than 150% of the max you could have gained. But ultimately, that’s nothing compared to the worst case scenario.

The 3rd Outcome: Apple Shares Rip Higher — R.I.P. Your Portfolio

Now imagine this: We get the October CPI report on the 13th. That’s the same event that sent Apple shares (and the rest of the market) tumbling on September 13th. But let’s imagine that amid all the bearish news baked into the market, we get a positive CPI surprise. The market goes gangbusters. Big rally, shorts are squeezed, all that. In this case: Those shorts being squeezed — that’s you. Curious how bad that can look? Here’s what happened when a trader from the famous options trading subreddit, Wall Street Bets sold several naked call options ahead of what turned out to be a sharp rally:

infinite risk, naked straddle, naked straddles, short straddle, short straddles, naked options
Source: Wall Street Bets

A Better Way to Make a “Rangebound” Trade in Apple

The magic of options trading is that there are so many different ways to make a prediction. You can absolutely make a prediction that Apple trades in a range between $130 and $152 without risking the life of your portfolio. For instance, you could:

Buy a Calendar Spread

In a calendar spread, you buy a longer dated option, for instance, expiring in January of 2023. And then you simultaneously sell an option at the same strike, at a closer expiration date (for instance, October 21st, the one cited in the article). At the time of writing, the $140 strike January/October call calendar spread would cost a debit of $6.67 (the most you could lose), with a max profit of roughly $3.98, and a max value of roughly $10.65 if shares expire at $140 on October 21st. The breakeven range of this trade is similar to the short straddle trade above — $131.62/$150.26 — except there is no risk of losing more than $667 dollars per spread purchased. 

That isn’t the only way you could make a rangebound prediction in Apple. You could also:

Sell a Short Iron Condor

Not all short options require with infinite risk. In a short iron condor, you’re selling a “strangle” (a call and a put at two different expirations), but you’re hedging your potential losses by buying a strangle outside of both short legs! To achieve a similar breakeven to the trade at the top of the article, you could look to the October expiration, and perform the following four trades simultaneously:

  • Sell the $132 put
  • Sell the $148 call
  • Buy the $130 put
  • Buy the $150 call

This would require a collateral of $0.98, and would offer a max credit of $1.02, for a maximum trade value of $2.00. Essentially, this is a 1:1 risk/reward trade that Apple remains within a range of $130.98-$149.02 by the October 21st expiration. 

In both of the examples we’ve given, you achieve a similar outcome — a prediction that Apple shares trade between roughly $131 and $150. However, the stakes for both option strategies compared to the naked straddle suggested by the outside source at the top of the article are night and day.

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Naked Options: Not Even Once

We’re sure the writer who published that short straddle trade idea in Apple had their heart in the right place. They likely didn’t understand the danger of selling naked options. If they did, they certainly didn’t communicate it in the aforementioned article — which doesn’t mention any of the downside risks involved with the strategy. But it’s okay, that’s why Market Rebellion is here. To spread options education, and to help traders learn to avoid painful mistakes. Maybe that writer will see this piece, and realize that they were advising their readers to play hot potato with a live grenade

Need more convincing? Ask Melvin Capital what happens when you take infinite risk positions. They’d probably tell you about how it feels to get the call no one wants to receive: a margin call

infinite risk, naked straddle, naked straddles, naked options, short straddle, short straddles
Pictured: Fear and Liquidation in Las Vegas. Source: New York Times

In short: Sometimes, trading means you have to take a risk. That’s okay — as long as it’s a defined risk. But if you’re considering taking on infinite risk, save yourself the trouble: It’s not worth it. Plenty of traders — even those with more capital and more experience — have been humbled by a single bad trade like the one described in this article. Naked options: Not even once.

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