The Risks Associated with Naked Call and Put Writing

Dec 21, 2020

Overview

Writing options, which is also called selling options, alone or as part of a covered strategy, has unlimited risk potential in your account when writing a call option, and the maximum risk for writing a put is if the stock price goes to zero, which could cause a significant loss. As the writer of an option, you have certain obligations you must fulfill, and these obligations are out of your control while you maintain an open short options position.

When you write a naked call, you take on the obligation to deliver long stock to the call buyer at the contract strike at any time until the expiration date. For this obligation, you collect the option premium from the buyer at the current option price; this premium is your maximum gain on this position. The maximum risk here is unlimited; the stock can go to the moon, and you are on the hook for the entire journey.

When you write a naked put, you take on the obligation to deliver short stock to the put buyer at the contract strike at any time until the expiration date. For this obligation, you collect the option premium from the buyer at the current option price; this premium is your maximum gain on this position. The maximum risk here is if the stock price goes to zero causing a significant loss.

The Risks of Writing Call and Put Options

First, most brokers require that you have options trading experience and meet minimum financial requirements before your account is approved to write naked options, and you will also need to maintain a minimum balance in your account. You should always make sure that you have enough money to cover the initial margin and consider an additional cushion amount in case the position moves against you. Always check with your broker regarding margin and account requirements before you begin trading.

Second, there is assignment risk throughout the life of the trade for American style options. Typically, options are assigned only when they are deep in-the-money, or when there is an advantage to exercising to capture a stock dividend. Still, an option writer can be assigned anytime up until expiration.

Finally, writing naked options generally requires a margin account, but you can also write a cash-secured put that covers the full value of the position.

Assignment Risk

First, most brokers require that you have options trading experience and meet minimum financial requirements before your account is approved to write naked options, and you will also need to maintain a minimum balance in your account. You should always make sure that you have enough money to cover the initial margin and consider an additional cushion amount in case the position moves against you. Always check with your broker regarding margin and account requirements before you begin trading.

Second, there is assignment risk throughout the life of the trade for American style options. Typically, options are assigned only when they are deep in-the-money, or when there is an advantage to exercising to capture a stock dividend. Still, an option writer can be assigned anytime up until expiration.

Finally, writing naked options generally requires a margin account, but you can also write a cash-secured put that covers the full value of the position.

Will I Get Assigned?

You can never really tell when you will be assigned. Once you write an American-style option (put or call), you have the potential for assignment, to receive (and pay for) or deliver (and are paid for) shares of stock. In some circumstances, you may be assigned on a short options position while the underlying shares are halted for trading, or perhaps while they are the underlying company is the subject of a buyout or takeover.

To ensure fairness in the distribution of option assignments, the Options Clearing Corporation (OCC) utilizes a random procedure to assign exercise notices to clearing member accounts maintained with the OCC. The assigned firm must then use an exchange-approved method (usually a random process or the first-in, first-out method) to allocate notices to its clients’ accounts that are short the options.

Important Note

Most stock options stop trading at 4:00 pm ET when the regular session closes, but many stocks continue to trade after-hours until 8:00 pm ET, even on expiration Friday, which may affect the intrinsic value and possibly the decision of a call or put option buyer to exercise an option, as exercise or a do not exercise decision can take place as late as 5:30 pm ET on expiration Friday.

Naked Put early assignment example – in-the-money exercise
XYZ stock is currently trading at $80 per share. Two weeks ago, you wrote a naked put when XYZ was trading at $95 per share. You wrote 1 85 Put for a credit of $2.00, or $200. The option is now in-the-money, and the 85 put you wrote is assigned to you. When this happens, 100 shares of stock are bought and placed into your account with a cost basis of $83 per share (the $85 strike price minus the $2 credit you collected initially). It is important to note here that you will need to have the $8,300 in your account to make this purchase.

Initial Margin Calculations

When writing a naked call, the margin is the greater of 1, 2, or 3:

  1. 100% of the option proceeds + (20% of the Underlying Market Value) – (OTM Value)
  2. 100% of the option proceeds + (10% of the Underlying Market Value)
  3. 100% of the option proceeds + ($100/contract)

When writing a naked put, the margin is the greater of 1, 2, or 3:

  1. 100% of the option proceeds + (20% of the Underlying Market Value) – (OTM Value)
  2. 100% of the option proceeds + (10% of the Strike Price x Multiplier x Contracts)
  3. 100% of the option proceeds + ($100/contract)

Keep in mind that your broker may change these margin requirements at any time, including during a trade, if market volatility increases. You can find additional margin information on the TradeStation website here: www.tradestation.com/pricing/options-margin-requirements.

Dividend Risk of Writing Naked Call Options

If you are writing a call option on a stock that pays a significant dividend, there is additional assignment risk if the call option is in-the-money and/or has less extrinsic (time value) than the dividend payout. If you are assigned short stock just prior to ex-dividend date, you could be responsible for paying the dividend.

Overnight Price Risk

Stocks and stock options trade for a limited time each weekday, but the world keeps revolving, and market-affecting news events can happen at any time and can have a significant impact on a naked options position. The problem is that these events are unpredictable, but you still should manage this risk. One way to manage this risk is by determining an appropriate trade size and the amount of dollar risk for your account on each trade based on your investment objective, financial situation and risk tolerance.

A good money management practice, known as ‘Fixed Fractional’ suggests that you should not risk more than one or two percent of your account on any one trade. And setting safety stop loss orders is on way to manage risk. But a stop loss order will not protect you from overnight or weekend events that could impact your position during a time when the options markets are closed.

Figure 1 below is a chart with a custom indicator that calculates the highest true range over the past 30 daily bars. We can use this value as a proxy for estimating the overnight price potential risk for an option position.

If we take the highest ‘true range’ over the past 30 bars, and multiply it by 2 (worst case scenario), then multiply that by $100, times the number of contracts you are trading, then multiply all that by the option Delta we are writing times 2 (as the market moves against us, Delta will rise), now you have an approximate overnight dollar risk for your naked option position.

Daily chart of AMD with a custom study “@MC Highest True Range.

Figure 1: Daily chart of AMD with a custom study “@MC Highest True Range.”

Do I need a Futures Account?

Have you ever been watching the evening news as some big event is happening, and you know that event will be bad for your stock or stock options position in the morning, but there is nothing you can do about it but wait and see? With a futures account, you may be able to hedge your positions or mitigate risk during Globex trading hours (Sunday to Friday) with the E-mini and micro E-mini futures and futures options.

Conclusion

Some of the biggest blown out traders throughout stock market history transpired with traders who wrote naked options. There are many ways to capture time value, like writing options that are covered by other long options, and although those are not completely risk-free, they do offer a safer way to capture time value, build market experience, and advance your options trading skills.

Discover the advantages of trading Options with TradeStation

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