Naked options are the collective term for option strategies that have undefined risk. These are actually popular strategies among some traders — but at Market Rebellion, we think of these strategies as “picking up pennies in front of a steam roller”. That is to say, no matter how “high probability” the strategy is at the outset, if the risk is undefined, there’s a chance that you could completely blow up your portfolio.
Options Can Be Safe
Let’s be clear: we are big believers in the importance of options. Options can provide traders and investors with plenty of benefits. And when used correctly, an argument can be made that they are less risky to trade than shares:
- You can use the leverage they provide to risk small amounts of capital.
- You can use short options to hedge risk.
- You can use ancillary metrics like volatility to give your trade an extra edge.
Overall, options allow traders and investors plenty of options in the way they deploy cash.
However, all of that goes out the window if you don’t manage your risk. So, selling naked calls or puts or deploying them in a strategy such as a naked straddle or strangle is not something that a Market Rebel does or recommends doing.
All it takes is for one low-probability tail risk event to wipe out years of positive returns. It’s the definition of picking up pennies in front of a steam roller. If you need confirmation, ask Melvin Capital how undefined-risk strategies worked out for them…
Spoiler alert: You can’t. Source: Bloomberg
Long story short: It’s not worth it. But for the sake of harm reduction, let’s talk about four popular naked options strategies.
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Naked Puts and Naked Calls: What Are They?
Naked calls are the term for selling or shorting a call option without holding shares or other long options in the same equity. On the opposite end of the spectrum, naked puts involve selling or shorting options without holding the capital to cover a potential loss — or other long put options in the same equity to cap the loss. The allure of these strategies is clear: collecting premium on a low-probably outcome.
But even low probability outcomes happen sometimes. And without clothing to cover your loss, you’re only left with naked options.
Naked calls are especially dangerous because stocks can theoretically rise infinitely. You might think you’re safe if the call you sold is far out-of-the-money, but what if they get bought out? What if they release a piece of news that completely changes the game? There are some things you simply cannot predict.
Alternatives To Naked Puts and Naked Calls
Instead of selling a naked call or naked put, consider:
- A credit spread
Rather than just selling an option, a credit spread involves buying another option within the same expiration as a hedge against the short option. If you sell a $100 strike put for a premium of $5.00, you might consider buying a cheaper, further-from-the-money $90 strike put for $1.00.
Of course, that’s $1.00 less in premium you can collect on the trade — but that’s also $9,000 less that you can potentially lose if the trade goes south. Not a bad trade-off. This works the same way with calls. Think of the long leg of your credit spread as catastrophe insurance.
But if you don’t want to sell credit spreads, you could also…
- Sell a covered call or a cash-secured put
Rather than using long options to hedge the short option, these strategies rely on 100 shares (in the case of a covered call) or 100 shares worth of capital (in the case of a cash-secured put). In either situation, you’re promising that capital or those shares to the option buyer at a cost basis equal to the strike price of the option you sold.
For example, you sold a $100 strike call? You get the premium for the option, and if (by the expiration date) the stock price is above $100, the buyer of that option will buy your 100 shares at $100 apiece.
Sold a $100 strike put? Same story in reverse — you get the premium for the option, and if the stock expires below $100, you buy 100 shares of the stock at $100 apiece. In either case, by allocating the collateral (with either shares, or the cash required to purchase the shares), you prevent yourself from undefined risk. On the other hand, if you don’t cover that undefined risk, you might get Melvin’d.
And if you thought selling a naked put or a naked call was dangerous, you won’t be surprised to find out that doing both in the same trade structure is even more dangerous…
Naked Straddles and Naked Strangles: What Are They?
A long straddle or strangle is a set of calls and puts bought in the same equity, at the same expiration. A straddle means they’re bought at the same strike, a strangle means they’re bought at separate strikes.
But a naked strangle and a naked straddle are the opposite — you’re selling that combination of calls and puts. As we covered above, the allure (and the risk) are both evident: you could take advantage of the elevated option premium, and if you get lucky, you could capture the premium from both options. On the other hand, if you are unlucky, that’s two directional opportunities to get blown up. Any adverse event could wipe out years of gains, or even send you into the negative. It isn’t worth it.
But if you want to take advantage of elevated premiums, you do have some choices.
Alternatives To Naked Puts and Naked Calls
Instead of selling a naked strangle or a naked straddle, consider:
- A short iron condor
A short iron condor has:
A similar goal: Taking advantage of elevated premium in a stock that you don’t think is going to move.
A similar payout structure (shown below):
And a similar construction: Instead of just selling a strangle, you would buy a strangle outside of both legs (below the put leg and above the call leg), which would define your risk.
But if you want a payout structure closer to the naked strangle, you could instead deploy:
- A short iron butterfly
Just like the difference between the naked strangle and the short iron condor, the naked straddle is similar in many ways to the short iron butterfly — rather than simply selling a straddle, you would buy a strangle outside of both legs. This caps your risk at the outer legs, changing the payout structure from the infinite risk naked straddle shown above to one that looks like this:
The Bottom Line: The cost associated with adding a few long options and capping your risk is always worth it. The magic of options trading is that there are so many different strategies to achieve the same goal. So if you’re ever considering one of the infinite risk strategies above — don’t. Consider one of the alternatives listed here, unless you want to end up like this guy:
Source: Wall Street Bets — because of course it is.
