How I Sell Naked Options
Selling naked options (selling a put or a call short) is perhaps one of the most controversial trading strategies. It involves the allure of trading options, but you lose one of the most marketable components of trading options, limited risk. With options selling-you carry significant risk. In exchange for carrying that risk, you receive, a high probability of a successful trade (a lot of winners). Although there is some variance to the data of the percentage of options that expire worthless-research shows that approximately 75% of options that are held to expiration expire worthless. Remember, that is if you blindly hold the options to expiration-this data does not include people who made profitable trades and closed out their positions before expiration which I will address. The problem that many of us are aware of is that the majority of time- you do make money, but, it is those few times a year when the position goes strongly against you that eats up your profit (or often times, the losers even eat up more than just your profits). Because there is such a high probability of winning trades, many people are drawn to this strategy (selling naked options)–and usually they love it for a long time, until the one bad trade hits, and then they realize how difficult this trading strategy can be. Despite the perils inherent in the strategy, I do sell naked options when I feel that there is a good opportunity. My success rate has been better than 90% for several years, and my losses relative to my gains have been small. I wanted to share some of the lessons I’ve learned regarding selling options. [Just an FYI, I did write an entry in the past talking about options themselves and how I use them on the long side-here is the link How I use options to enhance my trading performance
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Ok, here is the first trick. Do NOT sell any more contracts than you would have if you had just bought or sold the stock. I know, this one takes half the fun out of options. One of the big reasons that everyone loves options is the leverage. Don’t use it! Remember controlling risk is the key to this game. So, the first thing that I do–is determine how much of the stock I would take on if I were buying (if I were thinking about selling a naked put) the stock. I do my position sizing by looking at the prior volatility of the position relative to my account size–and I try to risk less than 1% of my account size. I go over how I do my position sizing in this article Risk is the Currency of the Markets!
After I determine how many shares I would buy–let’s say 200 using my calculations. I then consider selling (if I am going long)–2 put contracts (option contracts are generally equivalent to 100 shares). If my calculation came to 150-I round down and only sell 1 contract. I know–this doesn’t sound fun, but the way to think about this-is not what you can make, but what you are risking. And, when you are short a put contract you essentially are carrying the same risk as holding 100 shares of stock. On the flip side, if you are short a call contract-it is the same as being short 100 shares of stock from a risk standpoint. So you should take on no more risk than if you had entered the stock position–this will keep you in the game more than anything else.
Next, you need a trading methodology or system that has a high percentage of winning trades. It doesn’t even have to be a system that produces a lot of trades. I don’t use this strategy (option selling) frequently, I use it when it makes sense to use it. It is part of my/your arsenal of weapons to attack the market. Honestly, I don’t sell naked calls (not because I don’t think that it’s a good idea), I just don’t have a short strategy (what you need if you are going to sell naked calls) that is good enough (produces a high enough percentage of winners) to sell calls with. If you have a short strategy that works a high percentage of the time (say greater than 80%)–then use it. I use a strategy like Raptor II (which they sell at Trading Markets) to sell puts with. The reason why…more than 80% of the trades lose less than 5%. That is the kind of statistic you are looking for. But other types of strategies that work would be something like if the s&p went down 6 days in a row or dropped more than 3% in a week. Or, perhaps, if the 4 period RSI closed below 10. [Note: I’m just bringing out some starting ideas–I haven’t tested these]. Anyway, it’s these kinds of rare, and extreme events that usually create a lot of premium in the options (what you want to be selling)–and a high probability of success in the trade. As I wrote at the beginning-75% of the options expire worthless. Now, you are adding a strategy with a high probability of success on top of that further increasing your success rate. What I’ve found is that you can’t eliminate the losers; instead you must increase the probability of your winners. You really want a greater than 90% success rate with this strategy (option selling).
Now, when your set-up triggers you want to sell an option that is an additional 5% out of the money from where you would buy the stock. For index trades, I sell an additional 1.5% out of the money option. This means that if XYZ stock is trading at 50 and the trade triggers-sell the 45 put (if you are going long). After the beating that probably just occurred in the stock-there is usually a good amount of premium on the contract. What month do you sell? You sell the month that is decaying the fastest–that is the front month. Sell the front month contract unless there is more than 4 days til expiration-if that is the case, then sell the next month’s option contract.
Once you are short the option (exciting isn’t it?)–your goal is to get out. I almost never wait ’til expiration. I put in a good til’ cancel order to buy back the contract for 0.10. Why? First of all, this is about as good as you can do (buying back the option for 0.10). Sure if the contract expires for INITIAL_CONTENT–you make an additional $10 per contract, but why wait and carry the additional risk? You are now in a position-that if just a little time passes, you will most likely buy the contract back for INITIAL_CONTENT.10-if the stock bounces just a little-you will also buy the contract back for 0.10. And, even if the stock drops a little and some time passes-you will also be able to buy back the contract for 0.10. Inherently, this strategy of putting in a good til cancel buy order helps you take profits at the best possible time. Something that is often difficult for us traders–just when the stock bounces (in the case of put selling)-you get out of the trade for a profit (a time when many of us feel that we just want to hold on a little bit longer). But, why would you hold on for a bit longer–you’ve already almost maxed out your profit. Just buy the contract back for INITIAL_CONTENT.10. Remember, the name of the game is to have lots of winners-and reduce the chance of a bad loser as much as possible.
One additional caveat about exits-if the trading system that you are using tells you to exit the trade even if your good ’til cancel order did not trigger for 0.10–get out of the trade. Buy it back-just as if you were in the underlying stock. Most likely these will be winners too.
Now for the not so fun part….What about the losers? What do you do when the position goes against you? Essentially, if you have a stock or index system that has rules for entries and exits that you are selling options with. Leave your good til cancel order in for 0.10; if it doesn’t trigger, just buy back your option when the exit signal (or stop signal hits) for the underlying. If expiration comes and you are still in the position-just let the contract roll you into the stock position. After all, that is the position that you would have taken anyway had you just traded the original system. Your risk management here, is because of your position sizing.
I know that is a mouthful. I do feel that there is a place for naked options selling. Every once in a while-very high probability trades show up and the options have lots of premium tacked on. You essentially get to sell insurance at a time when everyone wants it. Just be careful…jump out of the trade with good til cancel buy orders. Don’t be greedy. Also, DO NOT SELL MORE CONTRACTS THAN THE NUMBER OF SHARES THAT YOU WOULD HAVE BEEN LONG (OR SHORT) IF YOU HAD JUST OWNED THE STOCK. (I hate to use caps, but this point is critical). I think if you stick to these concepts, you can consistently make money selling naked options despite the few losers that you’ll inevitable have.
Have fun…
Steven
Steve Gabriel, MD, is a regular contributor to
TheMoneyBlogs.com.