Selling naked calls can be tempting for a lot of traders due to the lower capital requirement needed to add these positions and no commitment to purchasing the underlying security. Traders selling naked calls can profit immediately from collecting a premium. Sure, selling naked options can generate quick income, but the risks involved can be severe and sometimes overlooked.
Our guide will take a close look at the primary risks associated with selling naked options and how traders can use this information and knowledge to make better-informed decisions as they trade. We’ll get into the specifics of why people like to trade these options in the first place, the risks that come with naked options (they’re often hidden), and some risk management strategies you can employ if you want to sell them.
What Are Naked Options?
Naked options refer to options contracts where the seller doesn’t own enough of the underlying security to fulfill their obligations in the event that the position goes to assignment. If the price of the security moves against the trader, this can expose them to great risks, like having to buy back the stock at the market price and sell it at the strike price, or sell the shares at a loss.
Naked options come in two options: naked calls and naked puts. In the first, the seller sells a call option without owning the underlying stock, while the second has the seller selling a put option. There are a few ways that traders can manage the risk associated with trading naked options such as using stop-loss orders to close out positions when the security price reaches a certain level, limiting the size of the naked call positions compared to the rest of the portfolio, and diversifying naked calls across multiple sectors, expiration dates, or securities.
Naked options can be attractive to some traders because the seller receives the premium cost of the options without having to buy a corresponding position to hedge against the potential loss that could come should the market move against the trader unfavorably. Selling naked options for premium income is good in low-interest-rate environments because traders can keep the premium if the options expire worthless. The traders generated income for themselves without having to buy the underlying security.
Why Traders Sell Naked Options
The allure of immediate premium income without having to buy a corresponding position to hedge potential losses is the primary driver behind so many traders preferring to sell naked options. In the event of naked puts, the seller is hoping the underlying equity or stock price stays the same or rises. With naked calls, the price of the underlying asset needs to rise above the strike price by an amount greater than the premium the trader paid for the call option. The potential profit increases the higher that asset’s price goes above the strike price.
Another tempting element of naked options is the lower upfront investment compared to covered options and their corresponding strategies. The traders aren’t purchasing the underlying asset as well, so their capital outlay is much lower. However, this can leave them extremely vulnerable to the losses incurred if the market moves against their position. The losses are technically unlimited, meaning it’s a lot of risk to take on.
The probability of trading naked options successfully is usually low due to the high risk that traders are taking just to keep their premium without buying the underlying security. The potential for losses is unlimited, and one bad market move against the naked option can lead to substantial losses for traders. It’s only a good move for traders who have plenty of background experience, have a high tolerance for risk (abundant capital), and have a strong grasp on the dynamics of the market. The probability of options expiring worthless and yielding profit is quite low, so it’s best left to the more experienced options trader, and even then, it’s a risk.
The Hidden Risks of Selling Naked Options
We cannot emphasize enough the great inherent risks that come to traders who want to profit from naked options. You’ll find, as we get deeper into this guide, that the only kind of traders who can really succeed with naked options are those with a high tolerance for risk and have the available capital needed to deal with the higher level of risks that could wreak havoc on their account balances.
Unlimited Loss Potential (Naked Calls)
Selling naked calls exposes traders to unlimited losses if the underlying asset rises significantly because they don’t own the underlying security, and they could have to buy it back at a much higher market price and sell at a lower strike price should the position go to assignment. Using naked calls is considered a high-risk strategy because there are massive potential losses, and there’s no upper limit because the stock price can rise infinitely in theory.
Example ScenarioSelling a call option on a stock that unexpectedly surges in price is a scenario where traders can incur some significant losses due to their obligation to sell their shares at the strike price. The trader would be facing a strike price that is now considerably lower than the market price which could lead to some missed opportunities on potential profits if the stock continues to rise.
Substantial Losses (Naked Puts)
Naked puts refer to selling a put option without owning the underlying asset. Substantial losses are likely to be incurred if the asset’s price falls significantly below the strike price. The key to a naked put falling apart for the trade is if the asset price drops sharply.
Example ScenarioSelling a put on a volatile stock that crashes due to negative news is a situation where the trade could face some searing losses as the out buyer is likely to exercise the options to sell the traders the shares at the strike price. This forces the traders to buy the stock at a price that’s considerably higher than the current market value.
Margin Requirements and Forced Liquidation
Often, when trading naked options, traders will run across high-margin requirements imposed by brokers to cover potential losses. This refers to brokers requiring a larger percentage of funds to be deposited as collateral in a margin account to act as a safety net for investors who are trading on margin.
Traders will receive a margin call if their accounts fall below the maintenance margin, which is the minimum required equity level to keep the account open. The margin call prompts the trader to deposit additional funds to bring their account back to the correct level, otherwise, they could face forced liquidation if the account balance stays below the maintenance margin requirements.
Market Volatility and Unexpected Events
When there are rapid price changes before the expiration date, traders using naked options can incur large losses. A few examples of significant market events that can impact the markets with sudden volatility include the release of companies’ earnings reports or other major geopolitical events like natural disasters or military conflicts.
“Black swan” events are unpredictable and highly improbable events that can significantly impact the markets and come with other severe consequences. While some black swans allow traders to benefit from using naked calls, many of these events leave traders vulnerable due to the unhedged exposure that comes with naked options. This can lead to catastrophic losses.
Psychological Stress and Emotional Trading
Another one of the risks associated with trading naked options is the possible emotional toll of watching potential losses grow exponentially. If the trader doesn’t purchase the corresponding positions to hedge against possible losses on the downside, they could be in a position where they are vulnerable to downside risk without any capital in reserves to deal with these losses. This phenomenon can significantly up the risk of the trader making irrational decisions under pressure, such as panic buying to cover losses.
Risk Management Strategies
To trade options responsibly, it’s key for traders to use effective risk management techniques to mitigate losses. Dealing with naked options is generally not a good move for the vast majority of traders unless they have significant experience and a lot of extra capital to take on the significant risks. Instead of using naked options, traders should focus on these alternatives:
- Covered Calls: Covered calls involve selling call options on a stock you already own. Traders buy shares of a stock, sell call options on those shares, and then keep the premium and the stock if the stock price stays below the strike price. The worst-case scenario is selling your shares at the stock price if the stock price rises above the strike price. Reducing risk by holding the underlying asset.
- Covered Puts: Covered puts involve selling a short stock and selling a put option simultaneously, where the trader is expecting the stock price to fall. Traders must sell a short stock and sell a put option with the same number of shares as the short position. Traders can get a premium from selling the put option, and this income can help lower the cost of the short position. There are some time decay risks involved with this strategy.
- Spreads: Options spreads involve buying and selling multiple options on the same asset. They involved similar options, but the expiration dates and strike prices are different. Using option spreads to limit potential losses also comes with the benefits of betting on different market outcomes and profiting from time decay on two different expiration options.
- Setting Stop-Loss Orders: Using the stop-loss tool helps traders automatically close their positions when the market moves against them by a certain amount. Traders can set stop-loss orders to exit automatically from any position when the stock crosses a predefined price as the stock price rises toward the set strike price.
- Maintain a Sufficient Account Balance: Because traders using naked options aren’t buying a corresponding position to hedge any potential losses, traders should have a healthy account balance with the money needed to take care of positions that get called to assignment.
Who Should Avoid Selling Naked Options?
If you’re new to options trading and have little experience with trading or investments, it’s not best to sell naked options as doing so well requires having a good grasp on market dynamics. It’s a practice that experienced traders have the most success with because they have the market knowledge to employ naked option trades and have a good chance of profiting from them.
Conservative traders are another type of investor that might not have the best time trading naked options. One of the reasons that some traders have better success with naked options is due to their higher level of risk tolerance and having the capital to back up the trades to secure a decent profit. Conservative traders tend to have a lower risk tolerance and are better off trading covered calls, covered puts, or option spreads.
Only experienced traders with a high-risk tolerance should consider this strategy. These traders have the money needed to reap a decent profit from trading naked options and to maintain the high level of risk tolerance associated with this move.
Tread Carefully When Selling Naked Options
Selling naked options can offer attractive profits to traders because they can receive the premium cost of the option upfront without having to buy a corresponding position to hedge against the potential loss. Although these can be tempting options positions to take on due to the immediate gratification of getting a premium upfront, these trades come with a lot of hidden risks that can be substantial and often unpredictable—they include unlimited potential losses, margin requirements that affect profitability, the scenario of forced liquidation, and the possibility of mounting losses on the downside that bring traders into the realm of emotional trading where they could make further mistakes.
However, selling naked calls can work for some traders, particularly those who have the capital to deal with any losses that come when not buying the hedging positions. If that describes you, it’s key to prioritize risk management like setting up stop-loss orders to minimize losses and use position sizing that doesn’t exceed 1-2% of your available capital.
Honestly, it might be preferable to explore safer options strategies due to the high degree of difficulty in selling naked options. Explore other options trading strategies to trade smarter and minimize risks.
