Can You Make Money by Selling Naked Options?

Selling Naked Options to Make Money in market

As investors become more educated and savvier, they look for new and exciting ways to trade the markets. This often leads investors to seek out the concept of selling naked options.

What does it mean to trade options naked? It doesn't mean they are trading from a European beach somewhere getting a line-free tan, but rather, the trader is selling options without having a position in the underlying instrument. For example, if one is writing naked calls, they are selling calls without owning the underlying stock. If they did own the stock, the position is deemed to be clothed or "covered."

The concept of selling naked options is a topic for advanced traders. As with any advanced topic, a short discussion such as this cannot cover every possible aspect of profit potential, risk control, and money management. In this article, we will be figuring out if naked options are even worth it.

A naked option, also known as an "uncovered" option, is created when the seller of an option contract does not own the underlying security needed to meet the potential obligation that results from selling (also known as "writing" or "shorting") an option.

Selling an option creates the obligation of the seller to provide the option buyer with the underlying shares or futures contract for a corresponding long position (for a call option) or the cash necessary for a corresponding short position (for a put option) at expiration.

If the seller has no ownership of the underlying asset or the corresponding cash necessary for the execution of a put option, then the seller will need to acquire it at expiration based on current market prices. With no protection from the price volatility, such positions are considered highly vulnerable to loss and thus referred to as uncovered, or more colloquially, as naked.

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How a Naked Option Works

A naked position refers to a situation in which a trader sells an option contract without holding a position in the underlying security as protection from an adverse shift in price. Naked options are attractive to traders and investors because they have the expected volatility built into the price.

If the underlying security moves in the opposite direction that the option buyer anticipated, or even if it moves in the buyer's favor but not enough to account for the volatility already built into the price, then the seller of the option gets to keep any out of the money premium. That typically means that option sellers win around 70 percent of trades. A setup that appeals to traders and investors who like to win the majority of their trades.

Naked Options vs. Covered Options

As noted above, a naked option refers to selling an option when the seller does not hold a corresponding position in the underlying security. In contrast, a covered option is an option sold by a seller who does hold a corresponding position in the underlying security.

For example, if investor A already owns 100 or more shares of Stock A, and then sells a call option on the stock, he is said to be selling a covered option. Selling a covered put option would require the seller to have already established a short position in the market by selling short 100 or more shares of the underlying stock. The 100-share requirement is because standard stock options are options on 100 shares of the underlying stock.

If the option seller holds a market position of fewer than 100 shares, then his sale of an option would only be partially covered. Selling a covered option negates the risk of selling the option but limits the seller’s potential profit in the underlying stock to the strike price of the option.

Naked Calls

A naked call position is usually taken when the investor expects the stock price to be trading below the option strike price at expiration. It is important to note that the maximum possible gain is the amount of premium collected when the option is sold. Maximum gain is achieved when the option is held through expiration and the option expires worthless.

A call allows the owner of the call to purchase the stock at a predetermined price (the strike price) on or before a predetermined date (the expiration). If you sell the call without owning the underlying stock and the call is exercised by the buyer, you will be left with a short position in the stock.

When writing naked calls, the risk is truly unlimited, and this is where the average investor generally gets in trouble when selling naked options. Most options seem to expire worthlessly; therefore, the trader may have more winning trades than losers. But with the unbalanced risk versus reward, a single bad trade can wipe out an entire year's gain (or more). Sound money management and risk control are critical to success when trading this way.

A trader sells a Call option at a strike price $50 at a premium of $1 but does not hold the underlying stock, which makes the option naked. Now, if the stock price rises to $80 on the expiry date, the trader has to buy it from the market at the current price as the option is in-the-money and he has to sell it to the option buyer because he is most likely to exercise the option. Thus, the trader incurs a loss of ($80-$50) = $30 on the transaction, as he will be selling it at $50. It would work in favour of the trader if the price falls to $40, in which case he will earn a premium $1, which is the profit as the option would expire worthless because it would become out-of-the-money.

A naked Call option can be disastrous if the price rises significantly. That’s why brokers do not allow using this strategy if physical assets are not there or the trade is not done with stop-loss orders. When trading with this strategy, a trader has sold the right for something which he/she does not own in physical form. A naked Call option is a bearish strategy where the only objective is to earn option premium and exit.

Risks and Rewards

A naked call is much riskier than writing a covered call because you have sold the right to something that you do not own. The closest parallel in the equity world is shorting a stock, in which case you borrow the stock you are selling. When writing naked calls, you sell the right to buy the security at a fixed price; aiming to make a profit by collecting the premium.

It is important to note that, since a naked call position carries major risk, investors typically offset part of the risk by purchasing another call or some underlying security. 

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Controlling Risk

The call writer does have some risk-control strategies available. The easiest is to simply cover the position by either buying the offsetting option or, alternatively, the underlying stock. Obviously, if the underlying stock is purchased, the position is no longer naked, and it does incur additional risk parameters. Some traders will incorporate additional risk controls, but these examples require a thorough knowledge of options trading and go beyond the scope of this article.

Generally, writing naked options is best done in months that are closer to expiring rather than later. Time decay (theta) is one of your best friends in this type of trade, as the closer the option gets to expiration, the faster the theta will erode the premium of the option. While it won't change the fact that this trade has unlimited risk, choosing your strike prices wisely can alter your risk exposure. The farther away you are from where the current market is trading, the more the market has to move in order to make that call worth something at expiration.

Naked Puts

A naked put is a position in which the investor writes a put option and has no position in the underlying stock. Risk exposure is the primary difference between this position and a naked call.

A naked put is used when the investor expects the stock to be trading above the strike price at expiration. As in the naked call position, the potential for profit is limited to the amount of premium received. The investor can make the most if the stock is trading above the strike price at expiration and expires worthless. If this occurs, the trader will keep the entire premium.

While this type of trade is often referred to as having unlimited risk, this is not actually the case. The risk in the naked put is slightly different than that of the naked call in that the trader could lose the most if the stock went to zero. That is still a significant risk when compared to the potential reward. And unlike the naked call, if the put is exercised against you, you will receive the stock (as opposed to receiving a short position in the stock, as is the case of the naked call). This would allow you to simply hold the stock as part of your possible exit strategies.

A trader sells a Put option at strike price $40 for a premium of $2 and the seller has no intention of buying the underlying stock. So this option is naked. If the stock price falls to $20 on the expiry date, the trader has to buy the shares from the buyer of the Put option at the strike price, as the option is in-the-money and the buyer would exercise his option of selling shares. So, the trader would incur a loss of (40-20) = $20 on this transaction, as he will be buying shares at strike price $40 instead of current price $20 from the market. It would work in favour of the trader it the price increases to $60. Then he will earn a premium $2, which is his profit as the Put option would turn out-of-the-money and expire worthless.

Naked Put option can be disastrous if the prices drop significantly. That’s why brokers do not allow using this strategy until a trader has excessive cash margin deposited. The naked Put option is a bullish strategy where the only high point is to earn option premium and exit.

These are some important elements while trading with naked options: 

1) Timing of entering a Naked option strategy. When the outlook for price movement is not certain, it can work against the strategy.

2) Stop loss orders if the fundamentals of the strategy reverse

3) Don’t trade in far month options i.e. expiry should be near one

4) Take protection as cash in hand for Put and physical security for Call options if waiting till expiry, otherwise exit before expiry

The Bottom Line

Trading naked options can be attractive when considering the number of potential winning trades versus losing trades. However, do not be taken in by the lure of easy money, because there is no such thing. There is a tremendous amount of risk exposure when trading in this manner, and the risk often outweighs the reward. Certainly, there is potential for profit in naked options and there are many successful traders doing it. But make sure you have a sound money management strategy and a thorough knowledge of the risks before you consider writing naked options. If you are new to options trading or you are a smaller trader, you should probably stay away from naked options until you have gained experience and capitalization.

Writing a naked call is an options strategy that carries significant risks because the security can move higher. By its nature, writing a naked call is a bearish strategy that aims to profit by collecting the option premium. Due to the risks, most investors hedge their bets by protecting some downside with securities or other call options at higher strike prices.

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