There are two sides to every options trade since there is always
a buyer and a seller in everymarket transaction. On options trades,
the seller is said to be writing anoption , and from the writer's
perspective, theoptions contract can be covered or naked.
Covered calls and coveredputs are written if the seller of the
option actually owns the underlying securities. With anaked option
, the writer, or seller, does not own the underlying security and
the risk can be unlimited.
Consider options in
Apple (Nasdaq: AAPL)
. An investor buys acall contract if they expect theshares of Apple
to move higher. The seller of the call contract would believe that
Atexpiration , if the price of Apple is above thestrike price of
the option, then the buyer can exercise the option and buy the
shares of Apple at the strike price. The seller of the option is
obligated to deliver those shares. If the seller of that contract
does not own shares of Apple, they have written a nakedcall option
and will be forced to buy shares at themarket price , resulting in
Theprofit for the writer if Apple falls is limited to the
premium they collected for the option sale, but they can face
significant losses if Apple moves up before expiration. In fact,
the risk with this strategy is theoretically unlimited.
Traders buying put options expect prices to fall. The seller of
theput option most likely believes that prices will rise. Naked put
option sellers will lose on the trade if the underlying security
declines in price.
Their risk is limited because prices can only fall to zero, so
the maximum loss is equal to the strike price while the maximum
gain is limited to the premium collected when the trade is
initiated.Naked put selling generally involves taking a large risk
in the hope of making a small profit on any individual trade.
How Traders Use It
Most option contracts expire worthless. This could be due to the
fact that many options buyers use options strategies as insurance
against a sudden market crash. This can involve buying deep
out-of-the-money puts, and the buyers expect most options to expire
worthless since crashes should occur infrequently. The infrequent
winning trade for theseput buyers will be very large, but a number
of losing trades will be completed with very small losses.
Naked option writers are taking advantage of the fact that most
options contracts will expire with no value and are selling option
contracts they believe have a small chance of being exercised.
These traders believe that selling deep out-of-the-money options
seems like a low-risk way to collect small premiums without having
to deliver the shares at expiration.
If a trader is able to do a number of these small trades
successfully, it could add up to significant profits over time.
However, occasional large losses could erase the small profits
accumulated over many trades.
Why It Matters To Traders
Naked optionsoffer potentially large profits over time. Since most
options do expire worthless there are a number of relatively
low-risk strategies that can be applied to sell naked options. But
if a large market move occurs suddenly, then the options seller
could face very large losses. In a market crash, put sellers would
suffer and could see the profits from thousands of small trades
lost in minutes.
Action to Take -->
Success in options selling could be very dependent on when the
trader begins selling naked options. If they enjoy a longbull
market before any put contracts are exercised, the large loss could
be paid from accumulated profits. If the market crashes shortly
after they begin to follow this trading strategy, the large loss
could be catastrophic.
This article originally appeared on ProfitableTrading.com:
Naked Options: Is the Reward Worth the
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