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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

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".

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