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Today's Featured Article
This article will review the basic aspects of naked options writing, touching on the philosophy that underlies options selling and on the goals of options writers. The reader will have the opportunity to walk step-by-step through the process of constructing a naked options trade, while gaining insight to different aspects of the strategy. This paper is divided into two parts. The first part is an overview of options selling. The second will give two examples of trades to connect the dots.
Selling options is quite revolutionary to "main-stream" trading. Unlike speculating on an underlying market or even buying options, the practice of writing (selling) options entails a different set of rules to follow. Moreover, while the goal of options-buyers and traders who speculate on an underlying market is to correctly predict the market's direction, the goal of an options seller is to gain from the passage of time, to gain from Time Decay. This approach is different than any conventional "direction picking" strategies.
Option traders would agree that approximately 85% of out-of-the-money options (options with strike prices away from the underlying market level) reach expiry with no value at all. Many options buyers would testify to watching their options value dissolve and disappear. This is because every option that is out-of-the-money has nothing but extrinsic value, or time value. The more time an option has until expiration, the more time value it has, and vice versa. Every day that goes by the option loses a portion of its time-value.
If an option reaches expiry date and it is out-of-the-money, it will expire worthless. Selling options is in many ways selling time rather than direction.
Focusing on the process of time-decay rather than on predicting market direction holds huge implications for the trader. As an option seller, one need not predict what direction the market is heading. The market does not need to move to a certain strike price and beyond. The market could stay range bound, and an option seller may still post a profit.
Selling options always entails risk and naked selling carries unlimited risk. But, nonetheless, many traders would concur that it is easier to guess where the market is not going rather than to guess where it will go. Moreover, unlike any directional trader, a trader who sells options and collects premium can be wrong about the direction of the market and still win. (When was the last time you were wrong about the market direction and still won?)
There are many option selling strategies and while all trading involves risk, some strategies are inherently riskier than others. This article describes the selling of naked options because it is, in many ways, the cornerstone of all options selling. Selling naked options means selling options without buying the underlying instrument or other options for protection.
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It is often said by many traders that selling naked options stands alone at the top of the pyramid in terms of risk in options trading. While selling naked options might not be appropriate for mainstream traders, it is a reasonable point of view that any strategy has its time and place. Moreover, it is possible that an extremely speculative position such as a naked option, if managed correctly, may result in less risk to a portfolio than a position that is more conservative in its nature and being managed poorly. With that said, naked options are inherently riskier than other options strategies such as credit spreads or calendar spreads because spreads
essentially carry limited risk while naked options do not.
Therefore, it is important to follow a strict set of rules, which a trader can set prior to entering the trade. The game plan may change from trader to trader depending on your risk tolerance, market outlook, and other individual factors. Nonetheless, here are some universal rules to follow when selling naked options.
Entry: Initiation of an options selling strategy is ideal when volatility is high. When any underlying market is volatile the options on both sides (calls and puts) become overvalued.
This means that a seller may collect premium above and beyond the "fair" price of the options. This also means that if the market calms down, the options would not only lose its time value, but also its overvalued premium -- which would represent potential profit for the seller. A trader may also sell options for their "fair value", seeking to gain from time decay alone. However, it is recommended to avoid selling options when volatility is low. In low volatility conditions, the seller of the options would actually collect premium that is lower than the option's fair value. This happens when the market is stagnant for a long period of time or when, in the stock indexes, it
experiences a continuous bullish move, which drives the Volatility Index (VIX) down. Once the market awakes from its sleep, or starts giving back ground for any reason at all, the options will increase in value -- representing potential loss to the options seller.
The three most prevailing approaches used to determine the levels in which the options should be sold are: support and resistance levels, standard deviations, and premium desired.
Recent levels of market support and resistance -- utilizing various market analysis systems to attempt and identify levels, which the market will likely fail to breach within a specified amount of time.
Standard deviations -- The implementation of statistical and mathematical formulas aimed at determining the percentages that a number of occurrences are close to the mean.
Premium desired - The options are sold with the intent of collecting a certain amount of premium, regardless of the distance from current market levels and regardless of other market influencing factors.
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Managing risk:
Managing your risk when trading options is done by creating spreads or by marking a "mental stop". The latter requires the discipline to actually pull the trigger when the moment comes. Two ways you may use to manage your risk when selling naked options are A) Pre-determine a value for the option in which the order to exit the trade would be placed. For example: if the option doubles in value, or if the option triples in value, the order to exit would then be placed. B) If the market reaches or breaks through a certain market level. For example: if you sold the S&P 1050 call, you can exit when the market breaks through 1000 level. Simply place the exit order if the 1000 level is
breached. The specific level may change depending on your market overview or how deep your pockets are, but regardless of what level you choose, you should always have a certain, specific level determined, and follow your plan. Too many traders get a "deer in the headlights mentality" when it is time for action.
Taking profit:
Here rests one of the great advantages of options selling over many other trading strategies. The edge derives from two elements. A) With most options selling strategies, when you sell an option and collect premium, your maximum profit potential is handed to you and is a given fact. The premium you collect is your potential profit. B) Every option has an expiration date. These two factors serve to resolve one of the main dilemmas of many traders -- when to take profit and when to exit the trade. Many options sellers would take profit when the option they sold loses 75%-80% of its value. Nonetheless, your maximum profit is defined by the premium collected and by the date of options
expiry.
Risk management:
Once the trade is placed, an options trader has several ways to manage the risk. The more sophisticated the strategy is, the larger the variety of possible risk management steps there are. Credit Spreads and Time Spreads allow the trader several options to choose from. However, due to the basic nature of naked options selling, it is arguable if an adjustment to a naked option position constitutes a creation of a new trade rather than managing the risk of the existing position. Therefore, for the limited purpose of this paper, it would suffice to stress and advise to follow the rules of profit taking and stop-loss mentioned hereto.
Let's take a look at an actual example: On Wednesday, October 7, 2009, the Standard and Poor 500 (S&P 500) closed at 1053.60. Though there are many indicators one may use, and there may be different opinions as to where some exact support and resistance levels may exist, most technical traders would agree that some formidable resistance is present around the 1080-1085 level, where as on the put side, the 1010-1030 range holds a promise for some support. Using these levels as a guideline, one can design a trade revolving around a bullish or bearish outlook of the market.
 If you cannot view the Standard And Poor 500 daily chart,
go here. (Standard And Poor 500, daily chart. Source used: FutureSource Workstation)
This concludes the first section of the paper. The next portion, coming soon, will use two examples of naked options selling to demonstrate the thoughts and details hereto.
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About the Author
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David Rozen is a senior account executive with Trader's Edge. He is fluent in various futures and options trading strategies. David's favored method of trading is a non-directional (delta-neutral) trading, utilizing pre-determined, limited risk structures. He trades options on several complexes, including the Stock Indexes (S&P 500), the Interest Complex (30 yr. Bonds), Metals, Grains and Currencies.
David served as a commander in a combat unit of the Israeli Defense Forces (IDF). His service and commanding experience play a great part in his ability to evaluate situations and make decisions under pressure in real time. After his service, David continued to earn his degree in Behavioral Science from Haifa University, Israel.
Three years after joining Traders Edge, David joined Gene Ratti and Bill Chieco to create a partnership within Trader's Edge. David is fluent in both English and Hebrew and serves clients across the United States as well as England and Israel. David's professionalism and passion for trading as well as his dedication to providing the utmost in service to his clients have swiftly made him a rising star at Trader's Edge. David resides in Morris County, NJ with his wife and two children. |
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