Lesson Overview

Custom Naked Call

What we call a "custom naked call" is a strategy we don't use too often but we have found success with when we do trade it. With this strategy we like to be fairly bearish on a stock but also might prepare ourselves for some upward moving short term. Again, like the custom naked put strategy we will use a combination of 2 different strategies to increase our chance of success. First we'll sell an OTM credit put spread and might take in a credit of say 0.40 on the sale. We'll then look to match that credit by also selling a naked call above the market for about the same credit. This will double our credit in the trade and help move the break-even point on the strategy much higher (thus increasing our probability of success). Hint: you can also think of this as entering an iron condor without the call side protection.

Show Video Transcript +

In today's video, we want to talk about a custom naked call strategy. What we call a custom naked call is a strategy we don't use too often, but we have found success with it when we do trade it, and that’s because it's really for a particular market and setup and we’ll talk about that later.

With this strategy, we like to be fairly bearish on a stock, but also might prepare ourselves for some upward movement short-term and that's why we’ll start to blend two strategies together here.

This is how we setup this strategy. The first thing that we’re going to do is we're going to sell an out of the money put and then buy one out of the money put at a lower strike, and that creates a credit put spread below the market.

You’re just doing a credit put spread below the market at a very high probability of success. The next thing that we’re going to do is we’re going to go above the market on the call side and sell one naked out of the money call option.

As far as risk is concerned, because you're still selling an undefined risk position on the call side, you theoretically have unlimited risk. However, we all know that your broker will only collect an initial margin required which is used in our case for position sizing.

If you are having trouble with position sizing or don't know how much to trade as far as your position size based on your account size, we do have a great guide that you can download.

It’s a PDF, a couple of page tutorial inside of our membership area at optionalpha.com. If done for a credit greater than the width of the put spread which we usually do a $1 wide put spread, you do have no additional risk to the downside.

We do prefer to do these trades when we have a great credit that's wider than that width of the put spread and leaves us with no downside risk. That’s the preference in doing these trades.

As far as profit potential, it can vary depending on the strategy and strike width and credit received, but your profit is maximized if the stock settles above the put spread and below the naked call.

In this case, the stock will trade in between the range that we have defined here on the chart, and both options spreads, the naked call and the put spread below the market will expire out of the money and worthless, and you'll be left with that total credit received as a profit.

As far as volatility goes, a drop in implied volatility will have a positive impact on this strategy because we are net sellers of options on both sides of the market.

We want to maximize our volatility edge we get by placing these trades only during very, very high market implied volatility situations. It’s such a key point to remember.

We’re net sellers on both sides. Therefore we have to do this strategy only when option premium is very expensive. Time decay will help this position as well because we’re looking to collect a credit on the premium received from the sale of the spread and the naked option.

The closer that we get to expiration, the faster a profit will materialize. As far as your breakeven points, it’s very easy to calculate with this type of strategy. You’re going to take the out of the money call strike that you sold short, and you’re going to add the overall net credit that you received.

That gives you your new breakeven point. Even after you sell the call above the market, you're still going to have a little bit of wiggle room in your breakeven point if you do this for an overall credit.

Let’s take a look at doing this trade on our broker platform in Thinkorswim. What we’re going to do here is we're going to go to an analyze chart with SPY, and we’re going to build this strategy out right now in front of you.

What we’re going to do is we're going to focus just on the March contracts. SPY is currently trading at about 204, and March contracts are about 57 days out.

We’re going to assume here that SPY has high implied volatility, we’ve already checked that. What we’re going to do first is we're going to sell a credit spread below the market at a high probability of success.

We’re going to start with the 189/188 call credit put spread and has a probability of being in the money of 19%. The probability that we lose on this trade is about 19%, 20%, meaning that the inverse of that is the probability that we win were about 80% chance that we win.

It’s a very high probability of success trade. What we’re going to do is we’re going to sell this strategy first, and we’re going to use that credit that we received to then go out of the money on the call side.

We received the $.11 credit for this strategy. On the call side, we’re going to go out of the money. We’re going to try to take in a net credit with this $.11 of more than $1 because the width of our strikes here is $1.

If we take in a credit more than $1, we have no risk to the downside. You can see these 212 options right here are trading for about 114. If I was to add this trade here, you could see the net credit that we receive $1.26. That’s definitely over that $1 threshold.

When we go to the risk profile, you can see this is what this strategy looks like. It’s a little bit harder to see, so hopefully, that makes sense. But you can see this is what the strategy looks like.

It has a little bit of a dip here in our profit right at where we sold that put spread below the market, but you can see this profit and loss line is definitely above the zero barriers because at this point, if the stock closes anywhere below 188, we get to keep the $.22 credit.

We take the $.22 credit… How we got there is we take the $1 width of the strikes, and we subtract that out of the credit that we receive and this leaves us with a $.22 credit if the stock crashes.

In this case, we have no risk to the downside, but ideally, we’d like to see the stock trade anywhere between about 189 and all the way up to about 213. It gives us a very wide range to profit on this trade.

If we go to the chart here of SPY, you can see that 189 all the way up to 213 is a pretty wide window to make some money on this trade and you only want to do this when implied volatility is very high.

182 is right about down here, and about 213 is somewhere about here. You can see a very wide profit window on this trade. It makes it a very high probability of success, but you want to focus on targeting this strategy when implied volatility is very, very high.

Key takeaways: Think of this strategy as entering an iron condor without the call side protection. You’re doing the same thing you would do on an iron condor, but you’re not buying that extra call on the top side.

We suggest you enter this trade for a net credit as we’ve shown that’s greater than the width of the put spread strikes so that you don't have any additional downside risk in the trade and that also helps out a little bit with margin requirement.

As always, I hope you guys enjoy these videos. If you have any comments or questions, please add them right below on the lesson page. Until next time, happy trading!

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