If you are like me, you have probably seen numerous emails about selling puts. Writing or selling “naked” options is selling options without having a position in the underlying stock or being long any options on the stock. For example, if a trader is writing naked calls, he is selling calls without owning the stock. If the trader did own the stock, the position would be considered “covered.”

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 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 making it more tempting to sell naked options. 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 being said, it also 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.

Here is an example:

 Apple Inc. (AAPL) is expected to announce earnings on February 1. The stock is currently trading around $177 and it has a potential support level around $170 from previous pivot levels. A trader can sell 10 February (Feb 16th) 170 puts for 2.25 each. As long as AAPL stays at or above the $170 level, the premium of $2,250 (2.25 X 10) is the trader’s to keep. In fact, AAPL can even drop a little below the $170 level and the trader can profit. The premium offsets potential losses and makes the breakeven point of the trade $167.75 (170 – 2.25).
 
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 to realize or forget is that each option contract usually represents 100 shares of stock. Getting back to the example, if AAPL traded down to $165 (just $5 below the strike) at expiration because of earnings, a loss of $2,750 ([10 X 500] – 2,250) would be incurred because of the 10 contracts. A seemingly innocent and odds in your favor trade to collect $2,250 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 that 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 many times, the risks of selling uncovered options are much greater than sources claim.

John Kmiecik, Market Taker Mentoring