Naked Option Selling: The Stupid Myth of "Unlimited Losses"

I’m an option seller and I think we get a bad rap. When people first hear about naked option selling and option writing they immediately hear about “unlimited losses” and “unlimited risk”. This ignorance and lack of understanding is frustrating to say the least.

It’s high time we bring this myth to an end! Frankly, I’m tired of hearing about it since I think it’s completely crap. It only occurs in theory, because in the real world, things are completely different.

So I decided to write this post to help educate and shed light on the topic for beginning option traders.

Enter The “But Kirk” Crowd

Now that I’ve said the things above I’m sure I’m going to get the “but” crowd who are going to take this to its literal end. Here is what they will say, “But Kirk…you are wrong. You can have unlimited losses when selling naked options!” So here’s my disclaimer…

IF you are a complete idiot and do absolutely nothing to manage risk whatsoever, YES you can have the potential for huge losses. This “unlimited losses” feature comes only with short call options and the theory is that the stock could risk to any possible level (seemingly with no restrictions) and if you held on long enough to your short option (which would be STUPID) then you could have huge losses.

This Risk Is Manageable

The so called “unlimited risk” feature then becomes completely manageable risk which you can deal with once you have some simple education.  There are thousands of option sellers who are making a small fortune selling naked options. Over the last 7+ years it’s been my bread and butter strategy. Besides, Warren Buffett’s Berkshire Hathaway also sells options for income.

As with anything in life, ignorance and stupidity only lead to unmanageable risk. Being successful selling options will always depend on your trading discipline and employing safeguards to manage risk.

Let’s Look At The Numbers

Selling or writing naked options when done in a disciplined manner coupled with proper protective trading techniques is no riskier than buying options. In fact, I’d even argue that option buying is more risky! Not only is it more speculative but the statistics show there are more traders who lose money as option buyers than option sellers.

Facts are facts people:

Based on a CME study of expiring and exercised options covering a period of three years (1997, 1998 and 1999), an average of 76.5% of all options held to expiration at the Chicago Mercantile Exchange expired worthless.

This bias in favor of put sellers can be attributed to the strong bullish bias of the stock indexes during this period, despite some sharp but short-lived market declines. Data for 2001-2009, still shows that annual CBOE trends remain the same as the major study done back in the late 90's.

Careless Traders Are Dangerous

I like coaching traders who are worried (probably because they are similar to me). Worried about risk first and profit second. These are the type of traders that will be very successful. They have a trading plan together and work that plan each day.

It’s the traders who are completely careless that give the rest of us a bad name. Admittedly, you do face the potential threat that the underlying stock may move continuously against your strike price. So if you just sit back and watch this all happen without doing anything then you may have no limit to the loses. Here’s the lesson: monitor your positions on a regular basis.

Techniques I Use To Manage ‘Unlimited Risk’

Okay I’ve talked about how you can manage risk when option selling, now it’s time to tell you how I choose to do it with my own account. I’m a very cautious and conservative trader as many of you know and thus have developed various protective trading techniques to offset the so called 'unlimited risk' factor. In my opinion, these simple things make unlimited losses a negligible risk in my portfolio.

Here are the strategy particulars…

Choose The Right Securities First

The most important consideration when selling options is what you decide to trade. Please for the love of god don’t do this on low volume, cheap stocks with no public interest. High volatility stocks like these are very risky for option sellers because they can gap higher/lower overnight and wipe out your profits.

Sure the premiums are attractive but don’t be lured into a false sense of security. I tend to play ETFs (Exchange Traded Funds) or Indexes instead of stocks. These seldom have dramatic one day moves and are less vulnerable to price gaps. This is because they are a basket of stocks and reduce non-systematic risk.

Buy Protection Whenever Possible

If you have a good profit, use some of the money to buy cheap protection. I usually prefer taking my naked positions and legging into a credit spread. This will completely and 100% eliminate the risk of unlimited losses should the market become more volatile.

Whatever you do, don’t get complacent enough to think that an early profit in the expiration cycle will stay that way. Markets can reverse and volatility can increase faster than you can stay liquid.

Don’t Sell Too Far Out

As an option seller we want to use time decay (Theta) to our advantage right? So don’t choose to sell FAR OTM options 4+ months out. These options have little time decay and you are also giving the market much more time to move against your position.

Instead focus on selling options with 2-3 months until expiration or shorter. This forces the market or security to make a strong directional move against you in a short period of time. If not you keep the premium and move onto the next trade.

Use A “Stop-Loss” System

I am not a big fan of setting hard stop losses with option selling. Mainly because you can set a stop loss and if the first day after you enter the trade volatility increase you could get closed out at a loss. There was still plenty of time left until expiration but now you are stuck with a loss.

Exiting depends on a whole lot of things that really have nothing to do with the price of the option; time until expiration, delta, theta, volatility, weekends, earnings, etc. But you should have something in place to mitigate risk based on your own risk tolerance. Experience will help in this area.

I’m sure you can think of more techniques and feel free to add them via Facebook Comments below. These 3 are just the ones I use and honestly are extremely simple and effective. At this point I think I have officially dispelled this stupid myth!

The Odds Are Stacked In Our Favor

Option sellers take maximum advantage of the option time decay. They understand that OTM options lose value quickly to the point of being worthless on expiration day. With this strategy we don’t need to correctly predict the market direction or market timing to generate income. An option buyer not only has to be right about the direction (which is hard enough) but also has to be right about the timing of the market move (impossible!). This puts the odds of trading success safely in your court.

Even with the odds stacked in your favor, you still take on risk with any trade right? I mean if there wasn’t some sort of risk then everyone would do it and get rich.

Be smart and educate yourself before trading.