Category: Stop Loss Orders

With another wave of earnings right around the corner, I feel the need to caution option traders and investors about selling “naked” or cash-secured puts over an earnings announcement. Whether you refer to it as writing or selling naked options, many option traders do not understand the risk. Selling a put option without having a position in the underlying stock or being long any options on the stock is considered a naked position. For example, if a trader is writing naked calls, he is selling calls without owning the stock. If the trader did own the stock, the position would be considered covered.

Can They Be Low Risk?

Can selling naked puts be low risk? The better question might be, what do you consider low risk? If you have invested money in the market, you are at risk. Traders often think it is a low-risk strategy that can offer consistent profits and indeed it can. Selling out-of-the-money (OTM) vertical credit spreads can be considered low risk because of the potential high probability of success. However, selling naked options can be dangerous, especially for new option traders, and should only be considered by more advanced option traders and those with large trading accounts.

Short-option premium can seem like an easy way to make a profit in trading. What traders forget is that the premium received from selling options is not theirs to keep, and there is substantial risk until the position is closed for a profit or expires worthless. Even though the premium may seem like a gift, it is not by any means. The risk of selling naked options can be significant.

Implied Volatility

 When the market moved lower recently, implied volatility levels and option prices increased. When the market rallied again, both dropped lower. When implied volatility is considered high, it can be a good time to sell premium like a naked option. Generally, after an earnings announcement, implied volatility starts to decline, which is good for naked option traders. That said, it is considered even more speculative if the position is held over the earnings announcement. A volatility event like an earnings announcement can produce some unpredictable price action for stocks.

Here’s an Example

Goldman Sachs Group Inc. (GS) is expected to announce earnings on April 14. At the time of this writing, the stock is trading around $330 and has a potential support level around $325 from previous pivot levels. A trader can sell 10 April (April 14^th) 325 puts for 5.85 each. As long as GS stays at or above the $325 level, the premium of $5.850 (5.85 X 10) is the trader’s to keep. In fact, GS could even drop below the $325 level and the trader could profit. The premium offsets potential losses and makes the breakeven point of the trade $319.15 (325 – 5.85).

With a volatile move, particularly after earnings, many naked option positions can wipe out a significant part of a trader’s account. What many traders fail to realize or forget is that each option contract usually represents 100 shares of stock. Getting back to the example above, if GS traded down to $315 (just $10 below the strike, which is not unheard of) at expiration because of earnings, a loss of $4,150 ((10 X 1000) – 5,850) would be incurred because of the 10 contracts. An option trader who thought he or she would easily make $5,850 because of the odds has now experienced a sizable loss.

Here’s the Gist

Option traders need to be extremely careful if they choose to sell naked options, especially over a volatility event such as earnings when premiums are overpriced. If a trader decides the risk of selling naked options is worth the reward, the best environment for selling option premium is when implied volatility is higher than historical levels but not over an earnings announcement. Many uninformed “experts” out there promote this type of activity as relatively safe. But let me tell you, the risks of selling uncovered options are much greater than many sources claim.

John Kmiecik
Senior Options Instructor
Market Taker Mentoring, Inc.

When to choose hard vs. mental stops as an options trader is a topic that comes up frequently in my daily group coaching classes and one-on-one coaching sessions. The truth is, it is not an easy answer. When it comes to options, stop losses can be a little tricky as compared with an investor who buys and sells stock.

Bid/Ask Spreads

For one thing, bid/ask spreads tend to be a little wider for options, which means there is more ground to make up than there would be for many equities, which have a tighter bid/ask spread. There are plenty of times in options trading when you are thankful to just get back to breakeven on some trades because of the spreads. Imagine an option position that has four legs like an iron condor. If the bid/ask spreads are wide, think how difficult it would be to do a hard or mental stop loss trying to middle the market. What is “too spready” is up to each option trader to decide. Below is a general rule of thumb I use when it comes to stop losses and options.

Outrights

When buying or selling a single-legged option, I tend to use a hard stop if the bid/ask spread for the option is reasonable. You will have to decide what is reasonable and that is a discussion for another day as stated above. I will put in a sell stop loss for long positions and a buy stop loss for short positions. Since there is only a single leg, the bid/ask spread is usually tighter. The screenshot below is a stop loss on a long call position. The current bid/ask spread is only 0.03 wide (that can widen, however) so there is less chance for slippage or a worse fill with the exit order set if the position declines to 1.00 or lower by becoming a market order.

When buying or selling an option spread, a mental stop is usually more beneficial because the bid/ask spreads tend to be larger due to multiple legs. If the bid/ask spreads are generally tight, I still consider using a hard stop especially if I am fortunate enough to have previously taken a profit on some of the position. The screenshot below shows a potential vertical call debit spread (bull call) and a stop loss. Notice that the bid/ask spread is larger than the long call listed above. Here the stop loss is set to exit if the position drops to 1.00 or lower in value again. The bid/ask spread is now 0.16 wide instead of just 0.03 like above.

Finally

Whether you choose to use a mental or hard stop is completely up to you, but consider how wide the bid/ask spread is as well. In addition, some option traders might sway from their mental stops when that level is tested and actually lose more money because of lack of discipline. That too is a discussion for another time. I hope this will give you a few things to think about. The most important part is that you have a stop loss (mental or hard) in the first place.

John Kmiecik
Senior Options Instructor
Market Taker Mentoring, Inc.