Some options traders prefer trading naked options instead of spreads. Naked options, also called uncovered options, allow traders to take a long (or short) position while collecting maximum premium.
For traders who do not shy away from risk, or those with significant trading experience, trading naked options is a successful options trading strategy to consider.
While there are better options trading strategies for beginners, selling naked options are an attractive, high-risk, high-reward strategy.
So, what are naked options, and should you trade this strategy?
Keep reading to learn more about the concept, including ways to mitigate risk when trading options.
Naked Options Defined
When a trader sells options without owning an accompanying long position, they are trading naked options.
If you sell a call but do not own a higher-priced call option as insurance, you are writing a naked call.
Selling a naked call has unlimited risk because the underlying stock price can increase indefinitely.
On the put side, selling naked puts carries maximum risk if the underlying stock falls to zero.
Traders may sell a naked call position if they anticipate the stock price to trade below the strike price when the option expires.
A trader can achieve maximum gain (keep 100% of the premium collected when selling an option) by having their short option expire worthless.
In general, David Jaffee does NOT recommend holding options through expiration because closing trades early will typically lead to less risk and greater overall returns (when deploying capital efficiently).
Naked Options: Risk vs. Reward
Because options tend to expire worthless, trading naked options seems like a good way to maximize the amount of premium you can collect.
Traders can certainly experience considerable success when trading naked options while having significantly more winning trades than losing ones.
However, the risks associated with naked options come into play during major market selloffs.
During March 2020, when the S&P 500 fell 36% in 33 days, many traders who were short naked puts ended up experiencing massive losses because they ran out of buying power.
One bad trade has the potential to damage a trader’s entire portfolio and outweigh any small wins.
The complete imbalance of risk versus reward makes it difficult to recommend naked options as a core trading strategy.
While David Jaffee trades naked options occasionally, he primarily trades vertical credit spreads due to the added protection it provides.
If you want to manage your risk when trading options, naked options are probably best used sparingly.
Naked Call Options: Controlling Risk
Traders that are determined to trade naked options can implement some strategies to mitigate their risk.
Option sellers rely on time decay (theta) and the likelihood that actual volatility will be less than expected volatility.
One way to mitigate your risk is by selling options that are significantly out-of-the-money (“OTM”).
By trading OTM options, you'll increase your probability of profit while also providing yourself with an opportunity to roll / manage the position if the strike price is challenged.
Stocks tend to increase in price slower than they fall. It's similar to the old saying that the “bull takes the stairs up, but the bear jumps out the window.”
As a result, when selling naked calls, traders are oftentimes able to roll and manage this position without experiencing violent moves.
Even so, David Jaffee recommends leaving at least 40% of your account as available buying power so that you won't experience a margin call.
Naked Put Options: Controlling Risk
Like naked call options, naked put options carry considerable risk.
Investors use a naked put option when they anticipate that a stock will trade above the strike price at expiration.
If the stock trades above the strike price and expires worthless, the investor keeps the entire premium.
The risk of selling naked puts comes into play when the underlying stock falls below the strike price.
A few times a year, it's common for stocks to fall very violently.
And when they do, there is correlation risk because many put options become in-the-money (potentially leading to a margin call).
While it's irrational to fear a large cap stock like Amazon going bankrupt, there is substantial risk with black swan events where stocks become oversold and traders experience many of their short put positions becoming in-the-money.
Oftentimes what happens in this scenario is that traders will be forced to close out their positions for a large loss.
The best way to protect yourself against this is by selling far OTM put options and by trading spreads (where you buy an option as insurance) – especially during periods of low volatility or where the market is overbought.
As discussed before, traders should also leave at least 40% of their net liquidation value / account value as a safety net to protect against large swings in their buying power.
David Jaffee from BestStockStrategy.com teaches the safest options trading strategy available and you can learn how to optimize your trading by enrolling as a student.
Naked Option vs. Covered Option
Traders can decrease the risk associated with an option by covering the position. By purchasing the offsetting option of the underlying stock, the option is no longer naked.
If traders are assigned, they can always write covered calls (or covered puts), or simply liquidate the position and re-sell the option.
With covered calls, traders can make money when the price goes up, goes down, or moves sideways.
A covered call protects you in case your shares decrease in value, and you can improve your returns because you're collecting additional premium.
Naked options are attractive to some traders because they permit traders to maximize the amount of premium they receive while also being relatively easy to manage / roll.
However, in general, David Jaffee prefers to trade credit spreads because of the greater capital efficiency and the protection against violent selloffs.
Naked options leave you more vulnerable, and it is essential to consider the risks involved when deciding between naked and covered options.
Learn the Best Options Trading Strategies
Whether you are new to options trading or an advanced trader, there is always room to learn and improve.
David Jaffee of BestStockStrategy.com has taught more than 1,500 students how to trade options.
David Jaffee’s online options trading course breaks down complex topics into easy-to-understand concepts.
As one of the few traders who share their actual trades on YouTube, and as a former Wall Street investment banker, David Jaffee teaches the most successful options trading strategies.
Learn how traders are winning up to 98% of their trades with the best trading strategy to increase your income and maximize your returns.
Frequently Asked Questions (FAQs)
What is a naked option?
A naked option, either a call or put, is when an option is bought, or sold, without a hedge. For example, a trader can sell a put and then their maximum loss would be if the stock filed bankruptcy. Contrast this with a "covered option" or "vertical credit spread" where your maximum loss would be the width of the strikes between the option that was bought and the option that was sold.
Are naked options risky?
Yes, naked options are risky if you trade too large and also if the market has a violent move in one direction. For example, in March 2020, the market fell 36% in 33 days and this caused many people to run out of buying power and close their positions at the most inopportune time.
What is a naked call option?
When buying an option, traders sometimes buy naked calls, as LEAPS, if they believe the underlying stock is undervalued.
Buying calls is more capital efficient than buying stock.
When selling calls, traders believe that the underlying stock will trade below the strike price at option expiration.
What is a naked put option?
When buying an option, traders sometimes buy naked puts if they believe the underlying stock is overvalued.
Buying puts is more capital efficient than selling stock.
Also, buying puts can act as a hedge and reduce portfolio volatility.
When selling puts, traders believe that the underlying stock will trade above the strike price at option expiration.
What are uncovered options?
An uncovered option is the same as a naked option. Where a trader assumes more risk and doesn't hedge their position.
Option sellers who trade uncovered options collect more premium but also assume more risk.
What about option selling risk management?
It's, in general, good practice, to sell options but also to buy options during periods when the market is trading at an extreme.
Buying put options when the market is complacent will help reduce portfolio volatility during a pullback, or a recession.