On Going Naked
In a previous post on WCI, I had mentioned that I had sold some March 2007 Calls.
When you sell a call and you own the underlying stock, its called selling (or writing) covered calls. In my case, where I don’t own the underlying stock, its called selling naked calls. I gave someone the right to purchase a stock from me at a certain price at a certain date in the future and in return I collected a small premium. [That's right, I don't own the stock yet I sold the option on it and collected some money. Makes me feel like I'm in the insurance biz!]
There is unlimited risk in selling naked calls (or puts). If the stock rises beyond my strike price [which is $17.50 in the case of WCI] I stand to lose the amount that it rises minus 17.50 minus the premium I collected up front.
When I entered the position last Friday, the stock was trading around $15. So it would have to jump 16.5% before being “in-the-money”. I collected a premium of $1.45 per share or $145 per contract. So the stock would have to be over $18.95 before I would start losing money. If the stock closes below $17.50 on expiration, the option expires worthless and I keep all the collected premium. If however it closes at say $18, then I don’t have to buy the stock at $18 and deliver it to the buyer. I just close the position before then and pay him the difference of $0.50 per share or $50 per contract. So even though the stock closed above $17.50, I’d still make $145-$50 = $95 per contract.
There are also commissions to be factored in. Interactive Brokers is amongst the cheapest[and most difficult to use] and charges $0.75 per contract.
The stock was down 4.5% today on no news so hopefully it’ll continue its slide into BK. The puts I had bought last month are now up 22%!!! The calls I sold on Friday have decreased in value and if I wanted to, I could close my position by buying them back at $1.25 per share or a 13.75% profit per contract.
I also sold some naked puts on a junior mining stock. I think it might move higher in the near future, however I don’t have any money to invest right now, and I’m not a big fan of buying on margin. Its trading at $11.25/share so buying 500 shares would run me around $5625. So I sold some puts with the Nov 06 expiration at $10 strike price and collected $35 per contract. The options expire in about 3 weeks. If the stock does nothing, I keep the premium. If it goes up, I still made my premium on them. If it drops, it would have to drop nearly 14% before I start losing money. But I was willing to buy them at this price anyway, so at least I curtailed my loss upfront!
[NOTE] Naked Option trading involves significant risk of capital. Victor Niederhoffer, a UC, Berkley professor and hedge fund manager lost 20 years worth of profits in 1 year through over-leveraging in naked option trades. Only gamble with risk capital when selling naked options. This is an extreme form of gambling. Do not take it lightly!
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October 24th, 2006 at 7:42 am
What is this junior mining stock?
October 24th, 2006 at 12:30 pm
Actually selling naked puts has a ceiling for losses
October 24th, 2006 at 1:56 pm
True – selling naked puts has the same loss potential as buying the stock long. The problem arises when people over leverage by selling too many naked puts or calls.
At one point I was into selling options as I liked the idea of being an insurance company and creating a security and keeping the money. But unless volatility is very high the upside is low relative to the potential for loss. It just does not seem attractive to me. On the other hand selling covered puts and calls (which is what most professional players do though a 1:1 option to share ratio isn’t needed) isn’t terribly attractive either – if you sell a covered call and the stock goes down you still lose but slightly less and if it goes up your gain is limited. All this might look more attractive if we went back to 2000 when option prices were so much higher than today though supposedly the risk of loss on a covered call was also much greater…
October 24th, 2006 at 2:03 pm
thanks for your insight moom.
i totally agree with you. I’ve been looking at options for a while now and good opportunities are few and far between.
i don’t like to sell covered calls – if the stock isn’t movijavascript:void(0)ng compared to the rest of the market, its time to move on!
Understanding option pricing is complex and confusing for many people.
October 24th, 2006 at 5:43 pm
Nirav: Response to your comment posted on my blog:
The way this works is that when you sell maked options some of your cash is set aside as a margin deposit alongside the cash received from your option sale. This total margin requirement is then continually adjusted as the value of options changes. Very similar to shorting a stock.
Does this help? (maybe you knew this already).
I’m still waiting for IB to approve my account. They sent me an e-mail saying it was fine but then I couldn’t do anything and they have answered that it is still under review.
October 25th, 2006 at 10:53 am
looks like you put a lot of time into this blog, so I clicked on your ads.
October 25th, 2006 at 11:03 am
thanks Jeff!
i’d return the favor, but you’re profile isn’t visible.
October 29th, 2006 at 10:21 am
OK wait – you don’t like buying on margin but you’re willing to sell naked puts & calls, which require margin and have tremendous amounts of risk??
If you’ve got the stomach/other things for it then by all means go for it. A friend of mine did very well selling naked puts for a couple years, until one day he almost got spanked very very badly by a couple of surprise news announcements.
Why not sell the short month option, and buy the back month LEAP (assuming there are LEAPs) at a much further out strike as insurance? This create basically a combination vertical/time spread. The Delta of the out of the money long dated option is such that it can actually be very beneficial to your position, but the price will be quite low for insurance if you buy a couple of strikes out. Then collect money for a few months or even a year or two on the front end.
Have fun!
Jonathan
October 29th, 2006 at 1:46 pm
great idea.
i’ll think i’ll do it that way.
its not that i don’t like buying on margin. i don’t paying the interest and leverage cuts both ways.
the naked options are a tiny part of my portfolio.
October 29th, 2006 at 3:25 pm
Ahh good… I’m all for higher risk strategies as long as people understand their place in the overall picture. =)