Is It Safe to Trade Naked?

We are in another round of quarterly earnings and that means implied volatility levels and option prices will rise. If you fancy selling premium like an investor selling cash-secured puts, you may be salivating a little more. But as we know with options, there are always risk/reward trade-offs. Let’s take a look.

Low Risk? 

Traders often think selling “naked” options is a low-risk strategy that can offer consistent profits and indeed it can. However, it can be dangerous especially for new option traders and should be left for more advanced option traders and those with large trading accounts.
Short-option premium can seem like an easy way to make a profit in trading. What traders forget is that the premium received from selling options is not theirs to keep until the position is closed for a profit or it expires worthless. Even though the premium may seem like a gift, it isn’t. The risks of selling options can be significant.

Implied Volatility

With this continued rise in the market and earnings season upon us, the implied volatility of many options has increased tremendously. And when implied volatility is considered high, it can be a good time to sell premium like a naked option. Generally, after the announcement, the implied volatility starts to decline, which is good for naked option traders. That said, it is considered even more speculative if the position was held over the earnings announcement. A volatility event like an earnings announcement can produce some unpredictable price action for stocks.

APPL Example

At the time of this writing, Apple Inc. (AAPL) was expected to announce earnings on Jan. 28. Just prior to the announcement, the stock was trading around $312 and had some potential support level around $300 from previous pivot levels. A trader could sell 10 February (Feb 21st) 300 puts for 6.35 each. As long as AAPL stayed at or above the $300 level, the premium of $6,350 (6.35 X 10) would be the trader’s to keep. In fact, AAPL might even drop a little below the $300 level and the trader could profit. The premium offsets potential losses and makes the breakeven point of the trade $293.65 (300 – 6.35).
That is all well and good, but many traders fail to limit their losses when the stock moves against them. Depending on the move particularly after earnings, many naked option positions can wipe out all or a significant part of their accounts. What many traders fail or forget to realize is that each option contract usually represents 100 shares of stock. Getting back to the example, if AAPL traded down to $285 (just $15 below the strike) at expiration because of earnings, a loss of $8,650 ((10 X 1,500) – 6,350) would be incurred because of the 10 contracts. A seemingly innocent and odds-in-your-favor trade to collect $6,350 has now become a sizable loss.

Last Word

The bottom line is traders need to be extremely careful if they choose to sell naked options whether or not premiums are overpriced. If a trader decides the risk of selling naked options is worth the reward, the best environment to be selling option premium is when implied volatility is higher than historical levels but not over an earnings announcement. There are many websites and subscription services out there that promote this type of activity as relatively safe. But oftentimes, the risks of selling uncovered options are much greater than many sources claim.

John Kmiecik, Market Taker Mentoring

Trader Education