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Naked Options
The Smart Profits Report: Issue #238
Tuesday, August 30, 2005
Naked Options: Words of Caution for a Lucrative Options Strategy
By Karim Rahemtulla
Chairman, Mt. Vernon Research
Readers frequently ask me about the potential downside to options investing. Questions like… How much can I really lose? More than I invested? If my options bottom out, will my broker swing by after dinner… for the keys to my house?
If you’ve ever seen the movie Trading Places starring Eddie Murphy, you’ll remember the end when the Duke brothers lost it all… and more… in the futures markets. In their case, the house keys were only the first things to go.
Heavy losses can happen, but only in certain situations. Today I’ll introduce you to naked options, an options strategy that can make you a ton of money if you know what you’re doing… or, if you don’t, simply treat you to the thrill of high-stakes losing.
Here’s what I mean…
How You Win Big or Lose Big With Naked Options
When you buy an option, a put or a call, you have the RIGHT, but not the OBLIGATION, to buy or sell the underlying shares. This means that your losses, if any, are limited to the amount you invested when you bought the option. Period.
But, when you get a little naughty and want to do some naked stuff (by not covering your positions), you can either make great returns - or find yourself in a mess.
For example, if you SELL a put option, you are obligating yourself to buy the underlying stock or commodity at a specific price on a specific date. So, if the underlying vehicle tanks, you’re on the hook for every bit of the loss.
At this point, you have two choices:
- Take a hit and buy back the option, or…
- Buy the underlying stock or commodity, and sell it for a loss.
An Example Of a Naked Option
Here’s and example of a naked option play. If you sold a $90 put on XYZ when it was at $100, you are obligating yourself to buy XYZ at $90, if it’s still trading at $90 or less at expiration. For carrying this risk you receive a premium. Assume for a moment that one day after the market closes, XYZ announced that it was declaring bankruptcy. The next day the shares open at $2. You are now on the hook for an $88 loss per share ($90 minus $2).
That’s quite a chink of change. But obviously, if the trade goes your way… that’s a handsome win.
So, the lesson is to know what type of options strategy you’re engaging in to determine your maximum loss potential. Just because something sounds neat - like people talking about “free money” from selling puts with naked options - the reality can be different. In the options market, as in any other market, there is no free lunch.
Good Trading,
Karim
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Today’s Smart Profits Cribsheet
- To get the most out of your options trades, you have to use a system. To read more about options trading strategies, check out Smart Profits #213, Options Trading Tools: Six Key Tools for Trading Options. Smart Profits #226 by Lee Lowell is also a great one, Hedging & Speculating: How to Enjoy Guaranteed Monthly Income With Options.
- Check out our Smart Profits Glossary for definitions of words like “naked option” or “put option” found in today’s article.
Related Articles:
- Uncovered Options: A Win-Win Trade that “Puts” You In the “Bookie’s” Seat
- Limit Orders vs. Naked Puts: Getting Paid to Place Them On Your Favorite Stock
- Short-Term Options: Two Ways to Make Them Work
