Thursday, September 2, 2010

Don't Be Afraid of Options - Part 5: Let's Get Naked (with Options)!

Please excuse the title of this post...I had to! :)

We have learned about buying call options and put options, and also writing a covered call option.  Let's continue with writing an uncovered or "naked" option in this post.  Why is it called "naked"?  This term has been coined because the seller of a naked option is left exposed to unlimited risk (in the case of a naked call).  Recall that when you buy a call option, the most you can lose is the amount of money you have spent buying that call option.  Also recall when you sell a covered call, when the underlying stock price rises above the strike price, all you have to do is hand over the shares that you already own of the underlying stock, and you're done.  Not so with naked options.

Naked Calls
For a naked call option, what you do is exactly the same as a selling a covered call, except you don't own any underlying shares.  Let's use an example to illustrate this.  You think Ford (Ticker: F) at $11.71 is priced too high and predict that it would fall by January 2011.  So, you sell a call option with a strike price at $12, set to expire in January 2011.  You get paid a premium of $1.10/share, which is what this option is trading at currently.  If the stock stays below $12, the option expires worthless and you get to keep the $1.10/share premium.

However, if your prediction was wrong and the stock rises to $14, the buyer of the option exercises his right to buy 100 shares at $12.  Who would sell him those shares?  YOU!  Since you sold him the right to buy 100 shares at $12, you have the liability of fulfilling that contract.  And since you don't actually own any shares of Ford, you need to buy 100 shares in the open market at $14/share and give them to the owner of the call option for $12/share.  So, you earned $1.10/share in premiums, but lost $2.00/share because the buyer exercised the option ($14/share you paid - $12/share the option owner paid you).  You netted -$0.90/share.

This is if you were lucky!  If Ford had skyrocketed to $22, you would need to pay $22/share in the open market and sell them to the option owner for $12/share.  You stand to lose $8.90/share ([$22 - $12] - $1.10 premiums).  The higher the stock goes, the higher your losses.  That is why your losses are considered unlimited.  As long as the stock goes up, your losses go up.  Therefore, I absolutely do not recommend writing a naked call.  By exposing yourself to unlimited risk, you stand to gain only a fraction of what you could lose.  This is the wrong side of the bet!

Naked Puts
Naked put options, although appearing similar to naked calls, are a completely different beast.  For one thing, your losses are not unlimited.  Say you sold a put option of Ford with a strike price of $11 and expiry date of January 2011 for $0.89/share.  You essentially have sold the right to sell shares of Ford for $11 at anytime before the expiry of the option to the buyer.  This is a bullish position.  If shares remain higher than $11, then the buyer would not want to exercise the option, because he can sell it for more on the open market.  However, if Ford tanks and goes to $10, the buyer can exercise that option, and you would have to buy the shares at $11.  If Ford totally went bankrupt and the shares went down to $0, you would still need to pay $11 for those same shares.  That's too bad...but that's the worst it can get.  The share price cannot go into negative territory.  Your maximum loss is simply the strike price of the option minus any premiums that you had received when you sold the option.

When Should I Write a Naked Put?
As I said, writing a naked put option is a bullish position.  It is especially useful when you are trying to accumulate a certain stock.  By writing a put option, you can potentially increase your returns and lower your risk (wait a minute, aren't those two polar opposites?  Keep reading...).  Let's use an example...I like examples, they make things easier to understand.

So, real life example...if you have followed my trading history, you would know that I've been accumulating True Religion stock.  I began buying when it was $29.31.  In merely 5 months, the stock has shed more than 35% of its value.  It's trading at $18.75 today.  This is one volatile stock!  No worries, I kept buying as it came down.  Lately, I've been thinking about writing naked puts (thinking only, because I need to "upgrade" my account, more on that below).  I checked out the prices of TRLG's put options and were quite surprised at how much people were willing to pay.  I looked at one with a strike price of $16 and expiry in April 2011, and people were asking for $1.95/share.  That's more than 10% of the stock price!

So, if I can successfully upgrade my account, and sell that same put option, I would immediately get $1.95/share for it.  If the stock goes down to $16 and the option is exercised, I simply buy 100 shares per each contract that I have sold.  Is that bad news?  No, not at all.  If I had not sold the option, I would still have bought the shares.  So, why not make $1.95/share while I'm at it?

In fact, by writing a naked put, I have lowered my overall risk.  Compare this...if I were to only buy the shares when TRLG dropped to $16, and the stock fell some more to $15, I would have lost $1.00/share. However, if I had sold that option, I would have been paid $1.95/share for it, and as a result, I'm still up $0.95 (the shares costed me $16/share - $1.95/share of premiums = $14.05/share)!  Now, that's having your cake and eating it too!  So, please, don't listen to the industry's seemingly intuitive and believable lies, "if you want greater returns, you have to take greater risks."  Selling naked puts when you are trying to accumulate a stock is what I call prudent investing!

The Catch
Yes, yes, there is a catch.  Not a big one though.  In order to be able to write naked calls or puts, you need to have a margin account, because after your initial transaction, you can still rack up additional losses.  Depending on your broker, they would likely limit how much risk you are exposed to.  So, chances are, they probably would not let you write too many risky naked options if you did not have the cash to back them up. You may either need cash sitting around in your account or the appropriate collateral (i.e. you may be required to sell your holdings) if the trade goes against you.

What Now?
I don't know about you, but I'm going to get my account upgraded!  When I talk with friends and such, most tend to think of options and margin accounts as very risky things, without really knowing what they are all about. It's sort of like a gun.  If a gun falls into the hands of an irresponsible person, it can be very dangerous and no one should allow that to happen.  However, if on the other hand, the person in question is a trained police officer with years of experience, we would feel much safer if he had a gun in his possession, compared to if he had not.  And so, that is the case with options.  Learn to use the tool and don't be afraid of it.

I've almost exhausted all of the things I can talk about options, without going into really fancy stuff, but wait, the best is yet to come.  I will give you a tool that can enable you to evaluate various option strategies, even those I have not talked about.  Stay tuned!