Selling Naked Options | Should You Sell Naked Options?
Selling naked options is a type of options trading strategy where the seller does not own the underlying asset that the option is based on. When someone sells a naked option, they collect the premium from the buyer but do not have any protection against potential losses if the option is exercised by the buyer.
Selling naked options can be a lucrative way of generating income from options trading, as the seller can keep the premium if the option expires worthless (out of the money). However, selling naked options also exposes the seller to unlimited risk if the underlying asset moves against their prediction (in the money). Therefore, selling naked options is considered a high-risk, high-reward strategy that requires careful risk management and market analysis.
In this article, we will explain what naked options are and how they differ from covered options. We will also discuss why traders sell naked options and what factors affect their profitability. We will then explore the risks involved in selling naked options and how to mitigate them. Finally, we will answer some frequently asked questions about selling naked options and provide some alternatives to this strategy.
What Does Selling Naked Options Entail?
"Naked options" refer to selling options (either call or put options) without holding a corresponding position in the underlying asset. Selling naked options is considered to be a high-risk trading strategy, as it can result in significant losses if the options expire in the money.
Selling naked options is similar to selling covered calls and cash secured puts, except you don’t have enough money to cover assignment.
Therefore, if the option goes far ITM, you risk a margin call.
Naked Options Explained
Naked options are options that are sold without holding a corresponding position in the underlying asset. For example, if a trader sells a naked call option on Apple stock, they are agreeing to sell 100 shares of Apple stock to the buyer of the option at a certain price (the strike price) on or before a certain date (the expiration date), regardless of whether they own any Apple shares or not.
Naked options are created when the seller of an option does not have enough cash or securities in their account to cover their potential obligation if the option is exercised. For example, if a trader sells a naked put option on Tesla stock, they are agreeing to buy 100 shares of Tesla stock from the buyer of the option at a certain price (the strike price) on or before a certain date (the expiration date), regardless of whether they have enough cash in their account to pay for them or not.
The seller of a naked option collects the premium from the buyer when they sell the option contract. The premium is determined by various factors, such as the current price of the underlying asset, the strike price, the expiration date, and the volatility of the underlying asset. The higher these factors are, the higher the premium will be.
The seller of a naked option hopes that the option will expire worthless (out of the money), meaning that the underlying asset’s price will not reach or exceed the strike price for a call option or fall below or equal to it for a put option. In that case, they get to keep the premium as their profit and have no obligation to deliver or receive any shares.
However, if the option expires in the money (meaning that it has intrinsic value), meaning that the underlying asset’s price reaches or exceeds the strike price for a call option or falls below or equals it for a put option, then the seller of a naked option will have to fulfill their obligation and deliver or receive the shares at the strike price. In that case, they will incur a loss equal to the difference between the strike price and the current market price of the underlying asset, minus the premium received.
Naked options are different from covered options, where the seller holds the underlying asset or has a corresponding position that can offset potential losses. For example, if a trader sells a covered call option on Amazon stock, they own 100 shares of Amazon stock that they can sell to the buyer of the option if it is exercised. Similarly, if a trader sells a covered put option on Netflix stock, they have enough cash in their account to buy 100 shares of Netflix stock from the buyer of the option if it is exercised.
Covered options provide a certain level of protection to the seller, whereas naked options do not.
Why Sell Naked Options?
Traders sell naked options for various reasons, such as:
To generate income from collecting premiums.
To speculate on the direction or stability of the underlying asset’s price.
To take advantage of high volatility or time decay in options prices.
One of the main benefits of selling naked options is that the seller can keep the premium as their profit if the option expires worthless. This can provide a steady source of income for the seller, especially if they sell multiple options with different strike prices and expiration dates.
Another benefit of selling naked options is that they can allow the seller to profit from different market scenarios, depending on whether they sell naked calls or naked puts.
Selling naked calls can be profitable when
The underlying asset’s price remains below or equal to
The strike price until expiration (out of money).
The underlying asset’s price decreases (bearish outlook).
The underlying asset’s price remains stable (neutral outlook).
Selling naked puts can be profitable when:
The underlying asset’s price remains above or equal to
The strike price until expiration (out of money).
The underlying asset’s price increases (bullish outlook).
The underlying asset’s price remains stable (neutral outlook).
Additionally, selling naked options can enable the seller to take advantage of high volatility or time decay in options prices. Volatility refers to how much an underlying asset’s price fluctuates over time. Time decay refers to how much an option’s value decreases as it approaches its expiration date.
Generally speaking, higher volatility and longer time until expiration increase an option’s premium, as they imply more uncertainty and risk for the buyer. Therefore, selling naked options when volatility is high or when there is still plenty of time until expiration can allow the seller to collect higher premiums and increase their profit potential.
Naked Call Option Risk Diagram on tastytrade
Drawbacks of Selling Naked Options
However, selling naked options also comes with significant drawbacks and risks, such as:
Unlimited loss potential.
Margin requirements and collateral.
Market unpredictability and adverse movements.
One of the main drawbacks and risks of selling naked options is that they expose the seller to unlimited loss potential if the underlying asset’s price moves against their prediction. Unlike buying an option, where the maximum loss is limited to the premium paid, selling an option can result in losses that exceed the premium received.
Another drawback and risk of selling naked options is that they require margin requirements and collateral from their broker. Margin requirements are minimum amounts of cash or securities that a trader must deposit and maintain in their account when selling naked options. Collateral is any asset that a trader pledges to their broker as a guarantee of their ability to fulfill their obligation if the option is exercised. Margin requirements and collateral are meant to protect the broker from the potential losses that the trader may incur from selling naked options.
Margin requirements and collateral can vary depending on the broker, the type of option, the underlying asset, and the market conditions. Generally speaking, selling naked options requires higher margin requirements and collateral than selling covered options, as they involve higher risk. This means that selling naked options can tie up a large portion of the trader’s capital and reduce their liquidity and flexibility.
Naked Option Example
For example, suppose a trader wants to sell a naked call option on Microsoft stock with a strike price of $300 and an expiration date in one month. The current price of Microsoft stock is $280 and the premium for the option is $2 per share. The trader’s broker requires a 20% margin for selling naked calls and a 10% collateral based on the strike price.
The trader will receive $200 in premium for selling one contract (100 shares) of the call option. However, they will also have to deposit $5,600 in their account as margin and collateral. $6,000 is about 20% of the strike price that you must pledge to your broker.
The trader will have to maintain this amount in their account until the option expires or is closed. If the option expires worthless, they will keep the premium and the margin and collateral will be released.
However, if the option is exercised or assigned, they will have to sell 100 shares of Microsoft stock for $300 each ($30,000 total) to the buyer of their call option, even though they do not own any Microsoft shares. They will then have to buy 100 shares of Microsoft stock from the market at the current price to cover their short position.
If Microsoft’s stock price stays below $300 at expiration, the trader will make a profit equal to the premium minus any commissions or fees. However, if Microsoft’s stock price rises above $300 at expiration, the trader will incur a loss equal to the difference between the strike price and the current market price of Microsoft stock, minus the premium and any commissions or fees.
A final drawback and risk of selling naked options is that they are subject to market unpredictability and adverse movements. The underlying asset’s price can change rapidly and unexpectedly due to various factors, such as news events, earnings reports, analyst ratings, economic data, political developments, etc. These factors can affect the demand and supply of the underlying asset and cause its price to rise or fall significantly.
Therefore, selling naked options requires careful market analysis and monitoring. The trader should be aware of the factors that can affect the underlying asset’s price and be prepared to adjust their position accordingly. The trader should also use stop-loss orders or other protective measures to limit their losses in case of unfavorable market movements.
How to Mitigate the Risks of Selling Naked Options?
Selling naked options is a high-risk strategy that can result in unlimited losses if not managed properly. However, there are some ways to mitigate the risks involved and increase the chances of success. Some of these ways are:
Assessing market conditions and trends before selling naked options. The trader should analyze the underlying asset’s price history, volatility, trend direction, support and resistance levels, etc., to determine whether selling naked options is suitable for their risk-reward profile and market outlook. Generally speaking, selling naked calls is more favorable when the underlying asset’s price is in a downtrend or range-bound, while selling naked puts is more favorable when the underlying asset’s price is in an uptrend or range-bound.
Setting realistic profit targets and exit points for selling naked options. The trader should have a clear idea of how much profit they want to make from selling naked options and how much loss they are willing to tolerate. The trader should also have a plan for when to close or hedge their position if the underlying asset’s price moves against their prediction or reaches their profit target. The trader should not be greedy or overconfident when selling naked options, as they can expose themselves to more risk than necessary.
Using stop-loss orders and other protective measures when selling naked options. Stop-loss orders are orders that automatically close the trader’s position at a predetermined price level if the market moves against them. Stop-loss orders can help the trader limit their losses and protect their capital when selling naked options. Other protective measures include using hedging techniques, such as buying offsetting options or futures contracts, or diversifying their portfolio with other assets or strategies.
Frequently Asked Questions (FAQs)
Here are some common questions that traders may have about selling naked options:
Who can sell naked options?
Selling naked options is not for everyone. It is an advanced strategy that requires a high level of trading experience, knowledge, and discipline. It also requires approval from one’s broker, as it involves high risk and margin requirements. Generally speaking, selling naked options is only suitable for traders who have:
A large amount of capital and liquidity.
A high tolerance for risk and volatility.
A thorough understanding of options trading mechanics, pricing, and strategies.
A sound risk management plan and money management system.
A reliable market analysis method and trading system.
How much capital do I need to sell naked options?
The amount of capital needed to sell naked options depends on various factors, such as:
The type of option (call or put), underlying asset, strike price, expiration date, etc.
The premium received from selling the option contract.
The margin requirements and collateral imposed by the broker.
The risk-reward ratio and profit target of the trader.
As a general rule of thumb, the more capital the trader has, the more options they can sell and the more profit they can make. However, the trader should also be aware of the potential losses that can result from selling naked options and should not risk more than they can afford to lose.
What are the tax implications of selling naked options?
The tax implications of selling naked options depend on various factors, such as:
The type of account (individual, joint, IRA, etc.) and tax status (resident, non-resident, etc.) of the trader.
The type of option (call or put), underlying asset (stock, commodity, currency, etc.), and holding period (short-term or long-term) of the option contract.
The amount of premium received and loss incurred from selling the option contract.
Generally speaking, selling naked options is treated as a short-term capital gain or loss for tax purposes, regardless of the holding period. This means that the premium received and loss incurred from selling naked options are taxed at the ordinary income tax rate, which can be higher than the long-term capital gains tax rate. However, there may be some exceptions and variations depending on the specific situation of the trader. Therefore, it is advisable to consult with a qualified tax professional before engaging in naked options trading.
How can I avoid assignment risk when selling naked options?
Assignment risk is the risk that the buyer of an option contract exercises their right to buy or sell the underlying asset from or to the seller of the option contract before or at expiration. When selling naked options, assignment risk can result in large losses for the seller if they do not have enough cash or securities to fulfill their obligation.
There are some ways to avoid or reduce assignment risk when selling naked options, such as:
Selling out-of-the-money options that have a lower probability of being exercised than in-the-money or at-the-money options.
Selling options with shorter expiration dates that have less time value and less chance of being exercised than longer-dated options.
Closing or hedging one’s position before expiration or before an ex-dividend date (for stock options) that can increase the likelihood of assignment.
Monitoring one’s position and account balance regularly and being prepared to take action if assignment occurs.
What are some alternatives to selling naked options?
Selling naked options is not the only way to profit from options trading. There are many other options strategies that can provide similar or better results with lower risk and margin requirements. Some of these alternatives are:
Selling covered options: This involves selling an option while holding a corresponding position in the underlying asset that can offset potential losses. For example, selling a covered call option on Apple stock while owning 100 shares of Apple stock.
Selling credit spreads: This involves selling an option and buying another option of the same type (call or put) but with a different strike price and expiration date. The net result is a credit (income) for the trader. For example, selling a call option on Tesla stock with a strike price of $800 and buying another call option on Tesla stock with a strike price of $850 and the same expiration date.
Selling iron condors: This involves selling two credit spreads of opposite types (call and put) on the same underlying asset and expiration date. The net result is also a credit for the trader. For example, selling a call credit spread on Netflix stock with a strike price of $500/$550 and selling a put credit spread on Netflix stock with a strike price of $450/$400 and the same expiration date.
Selling Naked Options | Bottom Line
It's important to note that selling naked options is considered to be a high-risk trading strategy, and it's not suitable for all investors.
It's essential to have a solid understanding of options trading and the underlying asset before engaging in this strategy and to be aware of the risks and costs involved.
It's also important to have a well-defined risk management strategy in place, such as setting stop-losses to limit potential losses.
If you are new to options trading, it is recommended you stick with cash secured strategies as opposed to naked options.
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