The Strategy of Selling Naked Options (07:03)

By Lawrence G. McMillan

This article was originally published in The Option Strategist Newsletter Volume 7, No. 3 on February 12, 1998. 

The attraction of selling something that may waste away to nothing leads many option traders to the strategy of naked option writing. However, the strategy is definitely not for everyone. Even for a suitable account, the strategy can “blow up” if not handled properly. Since volatility is so high these days – especially in index options – as compared to the levels of 1995 and earlier, it seems that the strategy is becoming more popular. Therefore, this article will outline some of the ways that naked writing – if undertaken at all – should be approached.

I have personally been trading options for nearly 25 years, and during that time, naked option writing has been the primary strategy in my personal account. While I don’t always have naked options in place, they exist much of the time. Thus, the guidelines that are included in this article are both practical as well as from personal experience.

The first and foremost question one must address when thinking about selling naked options (or any strategy, for that matter) is: “Can I psychologically handle the thought of naked options in my account?” Notice that the question does not have anything to do with whether one has enough collateral or margin to sell calls (although that, too, is important) nor does it ask how much money you will make. No, first one must decide if he can be comfortable with the strategy. Selling naked options means that there is theoretically unlimited risk if the underlying instrument should make a large, sudden, adverse move. It is your attitude regarding that fact alone that determines whether you should consider selling naked options. If you feel that you won’t be able to sleep at night, then do not sell naked options, regardless of any profit projections that you might read in this newsletter or elsewhere – the strategy is not suitable for you.

If you feel that the psychological suitability aspect is not a roadblock, then you can consider whether you have the financial wherewithal to write naked options. On the surface, naked option margin requirements are not large (although in equity and index options, they are larger than they used to be prior to the crash of ‘87 )

• Equity options: 20% of the stock price plus the option premium, less any out-of-the-money amount.
• Index options: 15% of the stock price plus the option premium, less any out-of-the-money amount.
• Futures options: futures margin, plus the option premium, less any out-of-the-money amount ...or...SPAN margin, which is based on historic volatility and could be considerably less.

In each case, there is a minimum margin that applies, no matter how far the option is out-of-the-money when the position is first established.

Note that as the underlying instrument moves up and down, the margin requirement will change due to the option premium and the out-of-the-money amount (if any). Thus, if you only allow the minimum margin on the day you initially establish a naked option position, you could receive a margin call on the next day, if the underlying instrument moves against you.

My attitude about naked selling is that you would prefer to let the naked options expire worthless, if at all possible, without disturbing them unless the underlying instrument makes a significant adverse move. So, out-ofthe- money options are the choice for naked selling. Then, in order to reduce (or almost eliminate) the chance of a margin call, set aside the margin requirement as if the underlying had already moved to the strike price of the option sold. In general, I prefer to cover any naked options if they go into-the-money (assuming they started as out-ofthe- money options to begin with). Thus, by allowing margin as if the underlying were already at the strike, there will almost never be a margin call before the underlying price movement forces me to close my position.

Thus, allow this margin:
• Equity options: 20% of the highest naked strike price.
• Index options: 15% of the highest naked strike price.
• Futures options: the underlying futures margin.

In my opinion, the biggest mistake a trader can make is to initiate trades because of margin or taxes. Thus, by allowing the “maximum” margin, you can make your trading decisions based on what’s happening in the market, as opposed to reacting to a margin call from your broker.

The recent blowup of the Victor Niederhoffer fund illustrates this concept: the disaster came about because he had sold naked puts, and had margined them more or less at the current index price at the time of the sale. Then, when the index collapsed under the weight of the double trading halts on that fateful day of Monday, October 26th, he had a margin call so large that his broker decided to buy him in. That buy-in came at the opening of Tuesday, October 27th. It was a disastrous event for the Niederhoffer fund: the prices paid to buy in the puts were so ludicrous that the $VIX index jumped to 55% from 37% the day before. The buy-in wiped out the fund. This will never happen to you if you allow the “maximum” margin to begin with, and then cover your naked options if the underlying trades at the strike price of the naked options.

“Suitability” also means not risking more money than you can afford to lose. If you allow the “maximum” margin as shown above, then you won’t be risking a large portion of your margin unless you are unable to cover when the underlying trades through the strike price of your naked option. Gaps in trading prices would be the culprit that would prevent you from covering. Gaps are common in stocks, less common in futures, and almost non-existent in indices. Hence, index options are the options of choice when it comes to naked writing.

Finally, there is one other “rule” that a naked option writer must follow: someone has to be watching the position at all times. Disasters could occur if one were to go on vacation and not pay attention to his naked options. Usually, one’s broker can watch the position – even if you have to call him from your vacation site.

Now that the “mechanics” are considered, how does one go about selecting naked options to write. My first criteria is that current implied volatilities of the options that I’m considering as a naked sale be in the 90th percentile of volatilities. That is, the current implied volatility reading is higher than 90% of all past implied volatility readings (note that historical volatility has not entered into the decision-making at this point). You may have some other criteria for determining whether the options are expensive, but it is imperative that you concentrate your efforts in situations where options are expensive. Don’t just keep writing naked options on the same underlying because it has been working in the past. If you do that, you may find yourself writing very cheap options (from the viewpoint of history of implied volatilities), in which case you could be subject to a very nasty surprise if implied volatility were to explode.

Finally, you must choose the striking prices of the options to write. I generally write fairly short-term out-ofthe- money options, and I choose the striking prices based on the output of the probability calculation program that we sell. The program can estimate the probability of the underlying ever moving to the strike prices during the life of the position, using historical volatility. If the probability of hitting either the upside strike or the downside strike during the life of the position is greater than 25%, I won’t take the trade.

In sum, then, if you want to write naked options you need to be prepared psychologically, have sufficient funds, be willing to accept the risk, be able to monitor the position every day, sell options whose implied volatility is extremely high, determine that the probability of hitting the strikes is less than 25%, and finally cover any naked options that become in-the-money options. If you can handle all of that, you should be profitable.

When covered writers are really naked writers: If you sell covered calls on stocks that you have no intention of selling, then you are really selling naked calls on those stocks. Think about it. If you have some very low-cost-basis stock that you don’t really want to sell, and you then sell covered calls against that stock, what do you wish will happen? Well, most certainly you wish that it won’t get called away. That is, you wish the options would expire worthless – exactly what a naked writer wishes for. Moreover, if the calls do go in-the-money, you will have to pay a debit to buy them back – and you may not have the money readily available (since you won’t be willing to sell any stock to cover the debit).

I have seen people operate this strategy, and they invariably try to sell a longer-term option to cover the debit of having to buy back the now-losing covered call that they sold. If the underlying stock continues to run higher, the writer is making no money from the stock price appreciation – a devastating emotional fact.

The worst case would be to do this with some relative’s stock who doesn’t really understand what you’re doing – imagine having to explain to the whole family why you lost a small fortune in Aunt Millie’s account merely by writing covered calls against her stock.

Lest you still doubt me, there was a famous case a few years ago in which a city’s pension fund was writing calls against their stock portfolio, but kept rolling them out because they didn’t want to have the stock called away. Eventually, the calls were so far in the money that the managers decided to just bite the bullet: buy back the calls, eat the debit, and hold the stocks. They made that decision in late September, 1987. Murphy’s Law strikes again. So, be very cautious about writing covered calls against stocks that you don’t intend to sell.

You might be better off using the stock’s equity to sell naked puts on other stocks – figuring that you’ll either acquire and hold those stocks if the puts are assigned, or you’ll be able to buy the puts back without the emotional baggage you’d have regarding the low-basis stock that can’t be sold.

This article was originally published in The Option Strategist Newsletter Volume 7, No. 3 on February 12, 1998.