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Naked Short Dos and Don'ts: Pointers for Shorting Options

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October 1, 2011
naked put short options
Fredrik Broden

Shorting options always sounds tempting, if for no other reason than the allure of getting something for nothing—or shall we say, profiting from the passage of time, rather than speculating on direction. If nothing happens, the option you sold has less value today than it did yesterday, and will have less value tomorrow than today. You might say in the case of short options that you have the wind at your back.

The catch, of course, is that you have open and potentially unlimited risk shorting options. And the magnitude of losses for the average trader tends to dwarf the magnitude of the winners—such that the expected gain of a net-shorting strategy ultimately equals the expected gain from a net-buying strategy. But that’s not to say shorting options is a bad idea. In fact, hordes of traders swear by it. Like any other trading strategy, you just need to understand the risks and follow a set of rules. If you don’t have any of your own, think about the following.

The “Short” List

1. BEWARE OF NAKED CALLS.

Wait, you probably thought this article would provide unbiased tips for shorting both puts and calls, right? Sorry. Shorting calls just has a lousy risk/reward profile. Period. Enter at your own risk, because the most you can “win” is the premium on the calls less commissions and fees, and your losses can run to the moon and back.

So let’s say you sell an at-the-money call for $2. You get the direction in the stock completely right and it gets slammed, say down $10. Your win? Excluding commissions and fees, $2. And if the stock really gets plastered, down $20, you win ... the same $2. On the flip side, with naked calls, you have unlimited risk. If the stock goes up $10, you lose at least $8 plus commissions and fees, and probably more, depending on how much time you have until expiration. As Larry David might say—pretty, pretty bad. And who wants to tie up all that precious capital, anyway? Or worse, trigger a margin call.

A different alternative?—Selling call vertical spreads. Short verticals contain a built-in hedge. Instead of, say, selling the XYZ January 50 calls at $2, consider selling the XYZ January 50-55 call spread at something like $1.50. If XYZ drops, or even just expires below $50, you still earn the premium you generated, minus commissions and fees, whether via a naked call or a call spread. But with the latter, your risk is capped at the long call. Sure, you generate less premium selling a spread as opposed to a naked call. But you can sell a greater quantity of spreads than you would naked calls. Why? Because you now have defined upside risk, and typically, your friendly broker (wink, wink) will require you to put up less capital on margin. This call spread maxes out at $5, the difference between the two strikes in the spread ($55-$50). Since you took in $1.50 of premium, you can actually only lose $3.50 (plus commissions and fees) per spread.

2. BEWARE OF SELLING NAKED PUTS AFTER A BIG RALLY WHEN EVERYONE’S BULLISH.

Covered calls sometimes get defined as “income.” At least the sold call part. The idea is that the premium received from selling the call against a long stock position is “income.” That of course assumes you don’t end up buying the call back at a higher price than you sold it for. But a covered call position carries nearly the same risk/reward characteristics as a naked short put. And we all know naked put shorting carries rather large risk. Namely, the stock might actually go lower and you could end up buying the stock at the put’s strike price, which may be significantly higher than where the stock is trading. There’s nothing wrong with using a naked short put or covered call strategy—just know the risks attached.

3. CONSIDER SELLING NAKED PUTS AFTER A SELLOFF WHEN VOLATILITY IS HIGHER AND THERE’S A HIGHER PROBABILITY OF AN UPSIDE MOVE.

It’s the reverse of point 2. Naked put shorting is an out-and-out bullish strategy. You are not only betting on the stock to go higher; you’re also betting on volatility to go lower. And since volatility tends to move opposite the stock, it’s almost like making a double bet. So you really want to time it well.

4. BEWARE OF SELLING TOO FAR INTO THE FUTURE.

Options lose value every day by virtue of time ticking away—this decay is known as theta. However, options don’t decay in a straight line. The closer to expiration they get, the faster they decay. In greek terms, the closer to expiration, the higher the theta.

In general, the farther expiration options (say, three months) trade at higher absolute premiums compared to shorter term-options (say, two months). But on the other hand, theta is higher for the shorter-term options. So as an options seller, you want to have it work both ways. You want to sell enough time value that you get a reasonable premium, in absolute dollars, for the options you sold. But you don’t want to go too far and not earn any money on time decay.

What’s a good risk/reward in terms of time until expiration? There are a lot of variables. All things being equal, selling options in the one- to two-month range can usually generate enough premium to be worthwhile, and also sets you up to earn some time decay.

5. CONSIDER SELLING NAKED PUTS ON LOW-PRICED STOCKS THAT HAVE BEEN BEATEN UP.

It’s tough to get too injured jumping out of a first-floor window. In that same vein, there’s relatively light downside risk selling puts in already low-priced stocks (under $10, for example). The stock itself can only go to zero. Put buyers obviously know this, so they won’t pay you an enormous premium when they can see the floor, too. But low-priced names around the $5 to $10 price range do tend to see some high implied volatilities, so it may be worth checking for potential opportunities.

Which Option Do I Choose?

So, now that you know a little more about the risks of trading naked puts, which options should you choose if you decide to proceed? Don’t make it complicated. Just create a simple system to follow. For example, refer to Figure 1 below:

1. Consider puts expiring in less than 40 days.

2. Consider options that have a greater than 60 % probability of expiring worthless.

naked short pointers shorting options

FIGURE 1: CONSIDER THE ODDS. Using a thinkorswim option chain, you can (1) check the days to expiration to ensure that there are 40 days or less, and (2) look for a greater than 60% probability of expiring worthless. In the chain pictured here, the 52 strike put has a 37.03% chance of expiring in the money—or a 62.97% chance of expiring worthless.

With step 1, you take care of rule 4 in the previous section. With step 2, you’re trying to stack the odds in your favor from the get-go in an attempt to win on more trades than you lose. You can find both criteria on the Trade page in the thinkorswim platform®. We can’t guarantee success, but it doesn’t hurt to put a well-thought-out method into place that you follow consistently. Trading short puts isn’t for every trader. But avoiding them out of a sense of fear may not be appropriate, either.

Qualify for Naked Selling

Only qualified accounts can trade short puts—"Level 3" trading. If you're only approved for Level 2 trading, you'll need to apply to upgrade your account to obtain the green light to do so. Log into your TD Ameritrade account and click on My Profile under the Home tab…

Under Elections & Routing, go to Option Trading and click on the Edit button to apply for an Options Upgrade. 

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