The call writer does have some risk-control strategies available. The easiest is to simply cover the position by either buying the offsetting option or, alternatively, the underlying stock. Obviously, if the underlying stock is purchased, the position is no longer naked, and it does incur additional risk parameters. Some traders will incorporate additional risk controls, but these examples require a thorough knowledge of options trading and go beyond the scope of this article.Time decay
Example 1:
Let's consider stock X for an example of a naked call write. The hypothetical trade mentioned below would be considered by a trader who expected the stock to move lower for the next few months or that the trend would trade sideways. For the sake of simplicity, let's assume X shares are trading at approximately $20 per share at the time of the trade and that the May 22.50 calls were trading at $1. A naked call write would be established by selling the May 22.50 naked (the trader has no position in X stock), bringing in $100 in premium per option sold.
Source: OptionStar
(Note: It is important to note that the right part of the chart above showing the risk of loss would extend indefinitely as the stock price continues to climb.)
Because naked call writing is an unlimited-risk proposition, many brokerage margin
Naked Puts
A naked put is a position in which the investor writes a put option Example 2:
As an example of writing naked puts, we'll consider the hypothetic stock Y. Let's assume that today is March 1 and that the Y is trading at $45 per share. For the sake of simplicity, let's also assume that the May 44 puts are at $1. If we sell a May 44 put, we will receive $100 in premium for each put sold. If Y is trading above $44 per share at expiration, the put will expire worthless and we will achieve our maximum potential profit of $100 per option sold. However, if Y is below this price at expiration, we can expect Y to be assigned to us, 100 shares for each option sold, at a price of $44. Our cost basis is $43 per share ($44 less the premium received), so that is where our losses would begin.
Source: OptionStar
Contrary to the naked call example, we have a maximum loss on this trade of $4,300 per option sold (100 shares of Y x $43 cost basis). This would only be if the stock (or ETF in this case) went to zero (unlikely in an index ETF, but very possible with an individual stock). The Bottom Line
Trading naked options can be attractive when considering the number of potential winning trades versus losing trades. However, do not be taken in by the lure of easy money, because there is no such thing. There is a tremendous amount of risk exposure when trading in this manner, and the risk often outweighs the reward. Certainly, there is potential for profit in naked options and there are many successful traders doing it. But make sure you have a sound money management strategy and a thorough knowledge of the risks before you consider writing naked options. If you are new to options trading or you are a smaller trader, you should probably stay away from naked options until you have gained experience and capitalisation.
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