Selling Naked Options (11:16)

By Lawrence G. McMillan

This article was originally published in The Option Strategist Newsletter Volume 11, No. 16 on August 22, 2002. 

The sale of naked options is a strategy that is probably over-used, in general. However, at the current time, with options remaining expensive, but with the skews lessening, volatility traders’ thoughts should turn more towards selling options these days. This is one of the riskiest option strategies, since losses could be large – even theoretically unlimited. However, the probabilities of such losses occurring might be lessened and the overall profitability turned in favor of the option seller. In this article, we’ll look at the specifics behind writing naked options successfully.

It’s Not As Easy As It Looks

Many novice option traders are tempted to write naked options because they are under the delusion that most options expire worthless. In fact, only about 30% of all options expire worthless (see box, page 5). Of course, one can sell deeply out-of-the-money options – those most likely to expire worthless – and increase those odds quite a bit, but even in those cases, it’s easy to get into trouble if you’re not careful. In my experience, only the most disciplined and experienced option traders are capable of managing a naked option selling strategy, and even then they run the risk of burnout. One floor trader, who had specialized in naked option writing for years, finally gave it up. He told me he was “tired of wishing his life away – always wishing it was the next expiration day, so my options would expire.” So, we’ll look at what makes a successful option seller.

I’ll tell you one thing right off the bat – the successful option seller doesn’t sell naked options all the time. Doing that ensures that one will eventually be in the way of a freight train as it roars down the track (Crash of ‘87, October ‘98 or the summer of 2002). One needs to know when to use the strategy and when not to. We’ll address this topic as well.

Benefits and Risks

The attractiveness of naked option writing includes, among other things, the fact that time decay works in your favor, that out-of-the-money options are often over-priced, and that existing equity can be used to fund the strategy. The biggest risk, of course, is that losses can be large, and that chaotic moves can occur with surprising frequency.

Basic Requirements

Your brokerage firm will require certain things. First, you must have a margin account. Second, you must have a minimum equity – which for some firms (obviously not interested in having their clients pursue naked writing) could be as high as $100,000. Most will be lower, although they could still be $15,000 or $20,000. Finally, your broker will require that you request and be approved for a higher level of option trading – level 3.

Margin Requirements

As stated earlier, the equity in your account – the loan value of stocks and bonds – can be used to finance your naked writing. The requirements are margin equity requirements, designed to ensure the broker that any risk engendered by the naked writing can be covered by the excess equity in the account. The broker does not actually loan you any money as he would if stock were being bought on margin, for example.

 The margin requirement to sell a naked option is:
 (P x stock price + option price - oom amount) x SPO
     where P = 20% for stock options; 15% for index
        SPO = shares per option (usually, 100)
        Oom means out-of-money
     The above formula notwithstanding, the minimum
     margin requirement is 10% x stock price x SPO.
 Example:  XYZ = 52   Nov 60 call = 3
  Margin requirement = (0.2 x 52 + 3 - 8) x 100 = $540
  (greater than minimum: 0.1 x 52 x 100 = $520)

Furthermore, naked options are marked to the market daily for the purpose of re-computing the margin requirement. Thus, if XYZ stock in the preceding example started to rise, the margin requirement would increase:
Assume that the following XYZ stock and Nov 60 call prices existed on that dates indicated, as the stock went into a strong bullish mode:

StockPrc           OptionPrc   .2xstk  oom   Total
52 (initial)           3        10.4   –8     $540
57 (5 days later)      5        11.4   –3    $1340
60 (15 days later)     6        12.0    0    $1800
70 (30 days later)    11        14.0    0    $2500

So, the margin requirement would nearly quintuple as the stock rose 18 points. In reality, the loss is $800 (the option was sold for 3 and is now trading at 11). Perhaps it would be best to close it out and release the margin for another trade.

Futures Options May Be More Advantageous

In general, futures option margin is lower than index option margin. This is really only comparable when discussing S&P 500 options, where one might be a seller of $OEX or $SPX options, but might get better use out of his money if he were to sell S&P 500 futures options.

Futures option margin, at its most advantageous, is based on SPAN margin. However, even if your broker does not allow you to trade on SPAN margin requirements, it is likely that the “old” futures margin requirements will be less than the CBOE-style index margin requirements for selling a naked option.
The “old” futures margin requirements were (are):

futures margin + option premium – ½ oom amount.

  Example:    $SPX = 900    Dec 850 put = 5

     CBOE-style Index requirement:
      (0.15 x 900 + 5 – 50) x 100 = $9000

     “Old” futures margin:
  $22,000* + (5 x 250**) – (½ x 50 x 250**) = $17,000
       *: futures margin for SP’s may vary
       **: SP futures are worth $250 per point

To compare these directly, though, one must adjust for the fact that the CBOE options are for $100 per point while the futures options are $250 per point. Dividing the “old” futures margin requirement by 2.5 will accomplish this. Thus, we have:

CBOE-style margin: $9000
“Old” futures margin equivalent: $6800

And, in fact, SPAN margin for futures options will generally be less than that. So, the futures market is more advantageous. One is taking the same risk in terms of the index falling and premiums inflating, so why not invest the lesser amount of money? It will increase your returns.

Are You Suitable For Writing Naked Options?

We have addressed this topic many times in past editions of The Option Strategist, but these qualities bear repeating. You can be considered “suitable” for naked writing only if 1) you are psychologically able to withstand having positions with potentially unlimited risk in place, 2) you have the financial resources necessary to margin the position properly (more, later), and 3) you have the trading experience to adhere rigidly to stops and to monitor your position at all times.

The Strategy Of Naked Option Writing

In this regard, we are going to discuss option writing as a strategy – as a branch of volatility trading, not as a way to acquire stock below current market prices (which is what people often say of writing naked puts). We are not talking about writing puts on stocks you “wouldn’t mind owning” (which, in fact, you do mind owning if they get put to you).
The five major strategy points are:

1. use index or futures options, not stock options. Stocks are much more chaotic than futures or indices. In fact, indices experience the fewest gap moves
2. only sell expensive options. We define this as options that are in the 90th percentile of implied volatility or higher. This is a very important criterion. As noted earlier, options were cheap prior to the largest market declines, not expensive. So, just by using this one criterion, you would have avoided being short options in the nastiest declines.
3. use our Probability Calculator 2000 to calculate the probability of the underlying ever reaching the strike price at any time during the life of the option. Be sure to use a high estimate of (historical) volatility in the calculator so it gives you something of a “worstcase” result (the historical volatility estimates can be obtained for free from our web site. The bottom line is that one should only sell options in which the probability of the underlying ever trading at or beyond the strike, during the life of the option, is less than 20%.
4. allow enough margin to reach your stop price. Since your stop price should be your striking price, you want to allow enough margin for the underlying to reach the strike price. If you do that, then no matter what kind of gyrations the index makes – up or down – you won’t get a margin call as long as the striking price is not reached. Thus, the naked option will expire worthless, and you won’t be bothered with a margin call.
   

   Example: SPX = 908 Sept 750 put = 5
   Initial CBOE margin:
   (.15 x 908 + 5 – 158) x 100 = –$1680,
   But minimum margin = $9080
   Margin if index falls to 750:
   Assume that the put is now trading at 30, due to a
   massive increase in implied volatility as the market
   falls rapidly. The margin at 750 would then be:
   (.15 x 750 + 30) x 100 = $14,250
   So, if you allow the larger amount, you won’t
   receive a margin call as long as the index stays
   above 750. Note: this example used CBOE-style
   margin, whereas futures margin would have
   reduced both figures.

5. Have somewhere to roll to. This is another criterion that augurs poorly for stock options – there are usually only a limited number of stock option strikes available. However, with futures options, strikes extend quite far in either direction. As long as there is somewhere to roll to, the naked option seller can roll his option if the underlying reaches his strike price. By doing so, he defers his profitability (thereby lowering his annualized return), but he keeps the position alive in hopes that the options will return to a much more normal, lower price.
   Example: $SPX falls to 750
   Sept 750 put = 30 (iv = 46%)
   Nov 675 put = 30 (iv = 48%)
   It is quite possible that the above sets of prices would exist. Even though the Sept 750 puts that were originally sold at a price of 5 have ballooned to a price of 30, this trader has no margin call because he allowed for this possibility. Furthermore, an even farther out-of-the-money put will generally trade with a higher implied volatility, such as the Nov 675 put. Thus, one can roll down 75 points in striking price value, for even money (both options trade at 30). There will be no increase in margin requirements, although one would have to wait another two months to capture his premium back – thereby lowering his annualized returns. Still, this is much better than buying the Sept option back at a $2500 loss.

Summary

If you adhere to these five rules, you should be able to operate a profitable naked option selling strategy. It is sometimes possible that a ratio spread – which also involves naked options – might improve profits, if you are able to predict in which direction the underlying might move. But, for a pure volatility play, the naked write is best (credit spreads, in my opinion, are a waste of time because you sell an expensive option and then turn around and buy an [even more] expensive option to hedge it with – sort of like spinning your wheels).

This article was originally published in The Option Strategist Newsletter Volume 11, No. 16 on August 22, 2002.