Novice traders often take on incredible levels of risk without realising the consequences of their actions. This can lead to a short career in the sharemarket. Professional traders tend to quantify the risk involved in any strategy, weigh up the rewards and make an informed decision as whether to engage the market.
One of the most common questions asked is whether a trader should write naked options. Naked options involve a high probability of receiving a limited reward in return for an unlimited level of risk. They imply that you are selling to initiate an option position where you do not own the underlying entity. In the right circumstances, writing naked options can be the ideal strategy. However, if you get it wrong, the consequences can be dire. There are several factors to consider. Let’s review ways you can limit your risk.
Many factors have a large impact on the price of an option. It is critical to come to an understanding of these factors to determine whether these instruments represent fair value to trade. These factors also have an impact on the cost and timing of the trading tactics you may consider implementing if the trade turns against you.
Some of the main factors determining the price of an option are:
• The level of risk – the greater the risk, the greater the potential reward. The closer the strike price of the option is to the share price, the more the inherent risk, and the greater the price of the premium.
• The level of volatility – in general terms, the more volatile the share, the higher the premium price. Choppy shares with greater distances from the peak to the trough of the share price action will attract higher premiums. For shares with a lower volatility level, the option/warrant premiums will also be lower.
• This information feeds into a calculation called historical volatility. If the market expects future volatility to increase, this affects a statistic called implied volatility.
• The time to expiry – the longer an option has until maturity, the greater the time value reflected in the price of the premium.
• Other factors such as delta, gamma and interest rate fluctuations also have an impact.
If the naked option trade I am considering does not provide an ideal combination of all of these factors, I walk away from using this as a strategy for that particular instrument. There is no point in entering into an option trade that contains unlimited risk unless the set-up is ideal. The risk must justify the rewards.
The perfect combination that would encourage me to write a naked option rather than employ an alternative strategy would be where the option had a limited time to expiry in a highly liquid share and option series. Ideally, the volatility set-up would suggest that the option is over-priced and likely to decrease in value. Comparing the implied and historical volatility levels will assist you in this quest. Before plunging into writing a naked option, also consider the expected strength of the move.
If a strong move downward is expected, writing a call does not often represent significant profit potential. It will result in a small fixed profit, regardless of the strength of the ensuing move in the expected direction. Another choice would be to buy a put option or short sell.
If a strong move upwards is expected, then writing an unprotected put position will not capitalise on this. Alternatives would include buying the share or buying a call option or warrant.
There are several other methods you can implement that do not involve writing naked options.
One way to learn about the options market is to write “covered” call options over shares you own. When you write options, you receive a small, fixed amount of money because you are selling to initiate the transaction.
The risk with written covered call options is that if the share increases dramatically in price, beyond the strike price of your written option (the level at which you wrote the option), it is likely your shares will be “called away”. When you write a call option, you are under obligation to sell your shares to the option buyer, which is usually enacted if the share price exceeds the strike price.
If you are exercised and the strike price is above the initial price you paid for the share, you will experience capital gain of the share as well as keeping the premium from selling the option. By writing these covered calls, you are making your portfolio work hard. Writing a call will bring in some regular income in particular circumstances.
Many traders have found that by implementing this strategy, their returns have safely increased, and that the additional cashflow has been a welcome contrast to awaiting dividend payments. If you want your blue-chip portfolio to return an extra 5 to 15% per year, this may be the strategy for you.
The concept behind some of the most effective credit spreads is that you limit your downside risk by “covering” your written position in some way with a bought option position. Written straddles and strangles also fall under the banner of credit spreads, but we will save the discussion of these concepts for another time.
An excellent text to enhance your knowledge of these types of strategies is Chris Tate’s ‘Option Trader Home Study Course’, available through www.tradinggame.com.au
A call bear spread involves writing a lower strike price call and buying a higher strike price call with the same expiry date. This is usually written out of the money, above the share price action. It is profitable if the share stays at the same level or drops in price.
Some people think of the bought position as being a form of insurance against a catastrophic loss. Any potential loss is quantifiable and known in advance, so provides a degree of consolation to the trader.
The payoff diagram above shows the construction of this option spread. A call is sold at A and a call is bought at B.
The reward is limited to the credit received, so it is probably not the ideal strategy if you expect an explosive move to the downside. For explosive moves you could short sell, or buy a put option. This strategy will not benefit from a change in volatility either, because you have both a written and a bought option position.
If the share price moves up, this will damage the position, so you can use an effective stop loss in order to recoup some of your investment. This is often a more effective alternative than letting both positions expire.
A put bull spread is where you sell a put option, and then buy a put option with the same expiry date, at a lower strike price. This is usually written out of the money, below the share price action. Share price action that moves sideways or upwards will lead to profit in this situation. This strategy yields a credit and limits your downside risk by capping your potential loss.
The payoff diagram below shows the construction of this option spread. A put is sold at A and a put is bought at B.
Both this strategy and the call bear spread benefit from a rapid loss in value. Traders who implement these strategies will benefit from a gradual progression in price, rather than dramatic or volatile directional price movement.
Call bear spreads and put bull spreads are of advantage to new option players because they give them a capacity to write options but with a risk management component built in. Along with covered calls, they represent a great learning ground so that you can learn the basics without exposure to unlimited downside potential.
When trading some instruments, such as index options, sometimes it seems almost impossible to avoid the possibility of writing naked positions. In order to limit your risk in this situation, remember to employ an effective stop-loss procedure, and to use a spread to mitigate potential disaster.
Some of the spreads that you could implement involve a call bear spread or a put bull spread as shown in the pay-off diagrams.
It would be foolhardy to write puts under an index without some form of protection such as a put bull spread. Any severe drop in the index would involve an unlimited potential for disaster. By building a put bull spread, they could have limited their downside risk, yet still backed their view.
As James Rogers states in Market Wizards by Jack Schwager: “Be very selective. Never trade for trading’s sake. Have the patience to sit on your money until the high probability trade sets up exactly right.”
This attitude will ensure your longevity in the markets and give you a chance to develop profitable strategies.
|Louise Bedford (www.tradinggame.com.au) is a full-time private trader and author of four best-selling books – The Secret of Writing Options, The Secret of Candlestick Charting, Charting Secrets and Trading Secrets. Register on her website to receive a free trading plan template and a 5-part e-course to get you trading like a machine.|