Naked Options

Options are one of the oldest trading vehicles man has ever used. Around a 1000 B.C Aristotle Thales predicted by the stars that there would be a bumper olive harvest and bought options on the use of olive presses.

When the harvest did in fact prove to be a great harvest Thales was able to rent the presses at a significant profit.

When you buy an option you have the right but not the obligation to buy (call) or sell (put) a specific underlying asset at a prearranged price on or before a given date.

Similar to futures, options can give the holder protection against adverse price moves.

Call options when bought allow you to buy an asset at a fixed price (strike price) on or before a specific exercise date.

Exercise date: some options can only be exercised on a particular date and they are commonly know as European options. Options that can be exercised on or before the due date are commonly known as American options).

A Put options is the reverse of the call option. When you buy a put option it gives you the right but not the obligation to sell an underlying asset at a predetermined date.

Now let's look briefly at the result of selling naked calls. In this scenario, the call writer simply sells the call and does not own any of the underlying stock to cover the short call. If the stock plummets, the call writer is very happy and relieved.

The premium of $400 is his to keep, and no one will be knocking on his door asking to buy the stock for $100 per share, since it is available on the open market for $50. It's his ideal scenario. Actually, any stock price at or below the strike price will be in his favor.

However, here's a very bad scenario. The call writer sells short a naked call. And the stock leaps 50%. He's got big problems. Somebody's going to want to buy XYZ from him for $100 per share, just as the option contract states.

But he doesn't own any shares of XYZ. So he now has to go to the open market and buy 100 shares at the current market price, which is $150 per share. He took in $400 of premium and now has to cover is with a $15,000 stock purchase, for which he will only receive $10,000. He loses $4600 ($10,000 - $15,000 + $400). Not a happy ending.

Do NOT even consider selling naked calls. Your broker probably would not allow you to anyway. However, until you really know what you are doing, don't sell naked puts either. When the bottom drops out of a market, naked put holders get very, very badly hurt. They are forced to pay high prices for low priced stock. You do NOT want to be in this position!

An option gives you something called leverage. Leverage is when you are able to control a large amount of money with a small investment. Each option contract lets you control 100 shares of stock for far less than the cost of buying those shares. But leverage is not the best reason to trade with options.

True, with the leverage that options afford you, you stand to risk less and make more, assuming things move in your favor AND in your time frame. Remember the expiration date! You have traded leverage for limited shelf life. If things don't move your way soon enough, you lose. So, what is the main reason to trade options? Spreads!

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