Spreads vs. Naked Options, How Both Can Make you Money!
Selling Naked Options simply refers to not having a protective leg to your trade, meaning the trade risk can be unlimited. Compared to a spread that limited risk with fewer profits in return.
Credit Spreads
Spreads can be defined as selling a naked option while buying a further out-of-the-money option to limit max loss.
For example, a put spread consists of selling a put option and then buying another put option that is further out of the money. The option you sold will be worth more credit than the Put that you purchased, thus creating a spread. The difference between those prices is the premium that you collect when executing the trade.
Benefits of Credit Spreads
Credit risks are great for limiting risk and capital efficiency. You can often sell more spreads for the same about of buying power reduction or risk as selling a naked option. Thus, you can collect more money because you can deploy more options.
Risks of Credit Spreads
The benefit of selling spreads is limited risk; theoretically, you can only lose the width of the spread. However, there are some situations where you end up owning shares. This happens if the option you sell is exercised. This typically occurs when the price is between the sold and bought option.
Selling Naked Options
A naked put can be defined as a contract for purchasing 100 shares of an asset at a certain price before or at a particular date. The risk is that the underlying goes below your strike price. In this case, you would simply be assigned 100 shares per contract.
The same principle is applied to selling a naked call option, except that you would then be selling 100 shares. If you do not own any shares, then you would be assigned negative shares, referred to as being short.
Benefits of Selling Naked Options
For most brokerages, when you sell an option, the money is credited to your account immediately. No matter what happens to the price of the stock, we keep the premium. If ABCD is above $80 per share at the expiration date of our contract, then we profit from the premium. If the stock price is below $80 at expiration, then our contract is exercised, and we keep the premium but are assigned 100 shares per contract of ABCD stock at $80 per share.
Even when the option is exercised, we still realize an incredible amount of savings because we were able to buy shares at $80 per share instead of $100. In either case, it is a win-win, assuming you are comfortable buying shares of the stock.
Risks of Naked Options
First, there is an obvious downside risk of selling a put option. If ABCD sinks to $50 per share and we sell the $80 Put, we are holding the bag at $80 per share. Yet, you are still in a better position than if you had purchased the shares at $100 per share when you originally sold the option.
Put options can become extremely risky if you begin to sell more options than your account can afford.
The amount of capital required to sell an option on a stock is normally much lower than it would be if you were to buy 100 shares outright. This can be a double-edged sword if you begin to sell more options than your account can handle.
For example, say we have a $10,000 account and sold one put at the $80 strike, expiring next month for $100 of premium. Our brokerage may only require $2,000 of buying power reduction to place this trade. This would be a very reasonable trade considering we have more than enough money to purchase 100 shares at $80 per share. That would only be $8,000. We could then do what we want with the remaining $2,000 plus the $100 collected, equaling $2,100.
However, some traders might think that they could sell five contracts because it only cost their account $2,000 in buying power reduction. Now, this could work out beautifully if the stock continues to rise over the course of the next month. On the other hand, this could quickly turn the other way if the stock price falls. In that case, the brokerage will then require more money to hold the contract due to the increased amount of risk associated with the stock. If the buying power reduction rises to $3,000 per contract, this quickly becomes a mess. Five contracts multiplied by $3,000 of buying power equates to the brokerage demanding $15,000 be in your account immediately. If you cannot provide the funds to cover, they will sell off your contracts for you, at a loss, without your permission.
For a fantastic resource for researching the market and taking advantage of having a community of like-minded investors, check out InsiderFinance by clicking here.
Get 20% off by entering CHRISTIANPARK20 when checking out.
Option Terms to know:
Contract: Is the right but not to an obligation to buy or sell 100 shares of the asset.
Call: A type of contract that allows the buyer to AQUIRE 100 shares of an asset at an agreed upon price and a specific date.
Put: A type of contract that allows the buyer to SELL 100 shares of an asset at an agreed upon price and a specific date.
Strike: Price of asset per share.
Asset: Underlying or ticker symbol (i.e., Apple = AAPL).
Premium: Amount of money received for selling a contract.
Expiration: A specific date when the contract expires.
Buying Power Reduction (BPR): The amount of capital a brokerage requires to sell an option usually is much lower than the actual cost of the shares.
Happy Trading!
Disclaimer: I am not a licensed financial advisor. All content is my opinion. Please do your research to make the best financial decisions.