Editor’s note: Selling naked options is a highly risky options strategy. Therefore, we recommend this article only for advanced traders who fully understand the risks of naked options.
Get paid to trade options
Establishing long option positions – by buying call options to play a soaring
stock or sector or buying puts to safely “short” a downtrending dud – is the
first strategy that successful options traders add to their quivers.
When you buy options, you’re counting on the stock to make a dramatic move either up or down, whereas selling options helps you to take advantage of little to no movement at all.
The opposite of buying (i.e. “buying to open”) options to hold long in your trading account is selling (i.e. “writing,” “shorting” or “selling to open”) calls or puts.
These have an opposite effect from their long-side counterparts, in that writing puts is a bullish bet that’s on par with buying calls. Similarly, when you sell calls, you’re betting on the stock going down.
For the same amount of effort, you can actually get paid to trade by selling options instead of buying them as a way of initiating a position. Although you may not make tremendous returns this way, you
can have a shot at making consistent income. But you absolutely have to know
what you’re doing because of the inherent high risk of option selling.
So, why not just buy puts instead of selling calls? Although they are both the means to a similar end, they have a very different risk-versus-reward strategy.
Focusing on on out-of-the-money stock options
When traders use margin, the broker incurs risk for the money it lends, so it takes steps to cover itself. Your broker will charge you interest for the right to borrow money and will use your securities as collateral. Further, most brokerages will require proof of some trading history and options knowledge before granting a margin account.
Here’s how buying on margin works: Suppose you buy a stock for $20 per share, and you want to purchase 500 shares. The margin account lets you buy another 500 shares, using the money your broker has loaned to you.
So, if that stock goes up to $30, you pocket the $10-per-share gain not on 500 shares, but 1,000, and you pay your broker back for the original loan.
Buying options on margin works the same way. Because an options contract represents 100 shares of the underlying stock, you would only need to trade five contracts to represent the same 500 shares. And because options can be quite inexpensive, you can control a full stock position for pennies on the dollar while still being able to take full advantage of anywhere from small to significant stock moves.
A ‘narrow margin’ can widen your payoff
But what happens when you want to short stocks or options?
How much margin you’ll need depends on the level of risk for each individual position. For example, an almost-sure win is to sell comfortably out-of-the-money options that will expire in just a few days.
If you sell an out-of-the-money option – which is standard practice when you’re looking to collect, and keep, the premium – then the margin will be small.
And if the stock finishes out-of-the-money, the options expire worthless. That’s a good thing when you’re selling short, because you get to keep the premium you collected at the outset of the trade!
On options expiration day, you wouldn’t have to do anything – the money was already in your trading account and you don’t have to pay commissions to close the trade.
Risks of ‘selling the farm’ without actually owning it
If the ideal mixture for potential short-term gains is to sell out-of-the-money options that are near their expiration dates in a margin account, then why isn’t “everyone” taking advantage of this low-effort strategy?
The risks for doing naked writes are real. They scare away many skittish investors
and they should. But nevertheless, professional traders do utilize this
The best way to find out if selling options is right for you is to ask your broker to give you an idea of what the margin will be before you take a position in the market. If you’re looking to sell options on stocks that don’t move around too much, your margin requirement may be lower than if you’re hungry to get into more-volatile names and sectors.
Mostly importantly, study the risks the you will incur in the worst case
Why can’t I sell options in a regular trading account?
You may be wondering why you would need a margin account when you’re selling options – i.e. not only are you not borrowing money to enhance your buying power, but you’re also not actually intending to do any buying.
Remember, margin accounts require extra approvals from your broker to take advantage of more-advanced options trading strategies. When you’re buying options, the most you can lose is how much you spend to enter the trade – that is your risk.
But when you’re selling options, the risks can be quite a bit higher. The privilege of being able to borrow your broker’s money in a margin account comes in handy when you find yourself in a situation where you may have to borrow that money to cover a trade that didn’t work out in your favor.
If the stock finishes in-the-money and you were counting on the option to expire worthless, not only will you have to pay to close your option trade, but you might be “assigned” by someone who bought the call or put to hold long in their trading account to fulfill the obligation that comes with being the short-seller.
Option buyers have rights if a trade goes their way, whereas sellers have obligations if it doesn’t. Sellers fulfill their obligations, whether it’s to buy or sell shares at the option’s strike price, to the buyers.
Ken Trester started trading options when the first exchanges opened in 1973. He has been a computer science professor at Golden West College in Huntington Beach, CA, where he also taught a course on stock options trading. Ken is also widely quoted in publications such as Technical Analysis of Stocks & Commodities and Barron’s.