July 16, 2007

Why Selling Options is not as dangerous as it seems.

I have been receiving questions on my trading of options. In particular, some of the people out there are wondering if it is too dangereous to sell nake puts or calls. After all, this is what they were told :

1) Theoraticaly, if you sell a call, your lost is unlimited as the stock price can go through the roof;
2) If you sell a put and the company goes bankrupt, you will lost alot of money.

My answer to them? This is not really true.

Selling naked option is not really dangerous. The academic and the broker like to tell you that. I believe you heard them said something like "oh, selling option have unlimited risk because in theory the price of the stock can go up and up, or it can go down to zero, so you will be caught...etc etc."

This will not happen for the following reasons :

1) you trade short options like you trade long options. You get out if you know you are wrong, or your stop loss is triggered;

2) your broker will not allowed that to happen because they monitor your margin like a hawk. Once your losses is greater than the margin, they will buy back your short option to ensure you have sufficient margin;

3) option has an expiry date, so do you think that within a 1 month period your stock will go through the roof or go down to zero?

Having said that, there is always the possibility of a stock like Enron that collapse overnight, and if you happen to short the put, than you are caught. However, your risk is really nothing more than if you own the share of Enron! For example, if you bought Enron share at say $100 for 100 shares, you pay $10,000. Now, if you sell a naked put on Enron share for strike at $100 for 1 option contract, you have an underlying exposure of $10,000.

If Enron goes under overnight, you lost $10,000 you bought the share. If you short the put, you lost $10,000 as well, but you still get to keep the option premium. You are no worst than those guys that bought the shares.

Moreover, I trade Exchange Traded Funds (ETFs), and because it's underlying shares are a basket of shares, ETF's will never goes to zero, unless each and every of the company in the ETF goes bankrupt, which is unlikely to be the case!


Number Six said...

You have a very impressive blog, unfortunately I've no business sense at all. Thanks for your kind comments on my blog.

Ermilo Gonzales III said...

I really like what you wrote here. You should write more about these topics in greater detail. I've been looking for reasons why "NAKED PUTS" are NOT dangerous. You popped immediately. Thanks for the encouragement and COMMON SENSE!

tifosikrishna said...

Your have an interesting view point and it is quite true.

Because of the asymmetrical risk profile for the buyer and seller of option, psychologically many "feel" that for amount of premium they pay for(especially for out-of-the-money) options, rewards seems unlimited, at least on paper.

Therefore people tend to buy options without much of forethought.

In most of the cases, these expires worthless and the writer pockets the premium.

sometime back i heard that more than 60% of options expire worthless....therefore, there is lot money already being made by selling options.