There are only four things to do as an option trader that do not involve a spread. Most option traders know that they can buy a call option as a bullish strategy and buy a put option as a bearish strategy. But many option traders have never looked at selling naked calls and puts. Of course, like everything in option trading, there are major pros and cons to selling naked options. Let’s take a closer look.
The Naked Option Strategy
A long call position gives the owner the right to buy shares of stock at the strike price up until expiration. Maximum profit is unlimited, and the risk is limited to the cost of the call. A seller of a call option has the obligation to sell shares at the strike price up until expiration if assigned (buyer exercises his or her right). Maximum profit is limited to the credit received and risk to the seller is unlimited.
A long put position gives the owner the right to sell (or sell short) shares of stock at the strike price up until expiration. Maximum profit is limited but quite extensive (strike price minus the cost) because that is as far as an underlying can fall and the risk is limited to the cost of the put. A seller of a put option has the obligation to buy shares at the strike price up until expiration if assigned (buyer exercises his or her right). Maximum profit is limited to the credit received and risk to the seller is somewhat limited but extensive (strike price minus the credit).
The Naked AAPL Put
Let’s take a look at an example using Apple Inc. (AAPL). At the time of this writing, AAPL shares broke through some resistance and were trading around $136 a share. Now the trader thinks that after a brief pullback the stock will once again move higher. An option trader can sell the July 130 put with 17 days until expiration because this is a potential area of support. The put option has a bid price of $0.50. Should AAPL stock be trading at or above $130 a share at expiration, the July 130 contract will expire worthless and the trader will keep the premium collected. (Do not forget to take any commissions the trader may pay from the equation.) All is good, right? Well, what if the stock falls below that area of support?
If AAPL falls another $10 to $126 at expiration, the put would expire in the money and the trader would have to buy it back to avoid assignment (long shares at the strike price). This could cost the trader a rather hefty sum. Assigning values, our investor collected $0.50 in premium. The 130 put expired with $4 in intrinsic value. The trader loses the $4, less the $0.50 premium collected, which results in a loss of $3.50, or $350 of actual cash.
Why Sell Naked Puts?
Depending on how far the trader sells the put strike out of the money (OTM), more times than not the put will expire worthless or the trader will be able to buy it back for less than the selling price and take a profit. In addition, selling naked puts is a good way to purchase at a specific price by choosing a strike near said target price. Should the stock price drop below the put strike and the puts be assigned, the trader buys the stock at the strike price minus the option premium received. Again, should the put not reach the strike price, the trader pockets the premium at expiration.
The Naked AAPL Call
Let’s now look at a naked call using the AAPL example from above. The option trader also notices some potential resistance around the $140 level that the stock may have trouble getting above. The trader can sell the July 140 call with 17 days until expiration at that level. The call option has a bid price of $0.80. Should AAPL stock be trading at or below $140 a share at expiration, the July 140 contract will expire worthless and the trader will keep the premium collected. Once again, all is good, right? Well, what if the stock moves through that area of resistance?
If AAPL moves another $10 higher to $146 at expiration, the call would expire in the the trader would have to buy it back to avoid assignment (short shares at the strike price). This could also cost the trader a rather hefty sum. The investor collected $0.80 in premium. The 140 call expired with $6 in intrinsic value. The trader loses the $6, less the $0.80 premium collected, which results in a loss of $5.20, or $520 of actual cash.
Why Sell Naked Calls?
Just like a naked put, depending on how far the call option is OTM, the most likely scenario is that it expires worthless or the trader can purchase it for less than it is sold. Many investors will sell call options on a stock position they already own (covered call), which has some great advantages. With unlimited loss potential, the naked call is considered one of the riskiest option strategies. A, perhaps safer way to structure a trade with a similar risk profile is to sell a call credit spread.
Option traders need to be aware of the potential risk of selling naked options despite the odds of profiting. In addition, the margin for naked options in considerably higher than option strategies with defined risk. But if an investor uses them wisely – by selling naked puts to acquire the stock at a lower price and selling calls as part of a covered call position, for example – he or she can enhance returns.
Senior Options Instructor
Market Taker Mentoring, Inc.