Please Note: Blog posts are not selected, edited or screened by Seeking Alpha editors.

Naked Options Sometimes Get Second Chances

|Includes: SPDR S&P 500 Trust ETF (SPY)

In last week's Option Update the Featured Option Trade was a naked call. The most significant disadvantage of a naked call is that potential losses are theoretically unlimited. While the risk of a limitless loss is not something a trader should ignore, that risk needs to be evaluated in context in order to make it meaningful.

Many trades have unlimited risk, such as shorting a stock. The risk of buying a stock, while technically not unlimited because the stock price can never fall below zero, is essentially the same. Not only is risk nearly unlimited when trading stocks, the opportunity for a "do-over" is rare. More often than not, holding on to a losing stock position will only result in more losses. Worse yet, adding to a losing position is asking for trouble. When a stock trade goes bad, the best solution in most cases is simply to get out and cut any losses.

When trading naked calls, especially those that are out-of-the-money, the ability to re-do the trade is built in. When a naked call results in an unrealized loss it can often be converted into a covered call which turns that loss into a realized gain.This method is similar to a second chance lottery and can be seen in the following example:

  • A naked call trade is opened by selling 10 out-of-the-money $136 calls on SPY with July 21 '12 expiration when the shares are trading near $133. The premium received is $1 per share or $1000 total
  • Given that the share price has recently found resistance at $136, the trader is expecting that resistance will hold and the calls will eventually expire worthless, resulting in a $1000 profit.
  • Several days into the trade, SPY unexpectedly spikes higher and breaks out above $136. At this point the calls might have a premium of $2.50 per share. Buying them back would result in a $1500 loss.
  • Rather than take the loss, the trade can be converted into a covered call by buying 1000 shares of SPY slightly above $136. Because the share price has broken through resistance, there is a high likelihood that the price will continue to climb. When the trade expires the calls will be assigned at $136 and the trader will keep the $1000 premium as profit. The $1500 loss was converted to a $1000 profit.

The only risk using covered calls to rescue a failing naked call is that the price encounters whipsaw at the exact point of the strike price. Even so, if a stop-loss of $0.25 is used, the trade can get stopped out four times before resulting in a true net loss. Each stop would equate to a $250 loss as the stock broke out above $136 and then retraced back below that level.

To limit the risk involved with whipsaw, rather than attempt to covert the losing trade to a winner it can be set up to break even instead, as can be seen in this example:

  • The same trade is opened using 10 $136 SPY naked calls.
  • SPY unexpectedly breaks out above $136, but because of the $1 per share premium received the trade will break even as long as the underlying remains below $137. When SPY does reach $137, the premium to buy back the calls might be $3. Rather than buy back the calls at a $2000 loss, 1000 shares are purchased at $137 turning the trade into a covered call.
  • Because SPY has broken out well above the $136 resistance, that level will likely become a new level of support. Using a $1 stop loss, the trade is much less susceptible to whipsaw than with a $0.25 stop. As long as the share price remains above $136 the calls will be assigned and the shares will be sold at a $1000 loss while the $1000 premium is retained. The $2000 potential loss was reduced to zero.

Questions about these or any other option trades are encouraged. Please enter them in the comment section below, or email them to optionscientist@zentrader.ca.

The preceding is a post by Christopher Ebert, who uses his engineering background to mix and match options as a means of preserving portfolio wealth while outpacing inflation. He studies options daily, trades options almost exclusively, and enjoys sharing his experiences. He recently co-published the book "Show Me Your Options".

Related Options Posts:

Option Greeks More Important Than Greece

Option Indices Signal Bear Market

Markets Are Stuck In A Stalemate