Traders Beware of this “Options Deathtrap” in 2016

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I recently debunked the seven greatest option myths, including one of the most popular ones: options are too risky and you can lose ALL of your money trading them.

Now that one was easy to disprove with one simple and indisputable fact: options were originally created to help mitigate risk.

But there’s something else that I’ve been seeing and hearing that is particularly troubling…

And it’s something that’s more dangerous and disturbing than the option falsehoods we discussed last week.

What’s even more alarming is that, after the chaos that unfolded in the markets last week, traders may actually believe it.

You yourself might have even heard this… and you might even be strongly considering it.

But before you make the WORST decision of your trading career…

Take five minutes and read this.

The Best Way to Lose ALL of Your Money in 2016 is the One That’s Being Encouraged the Most

My best friend, the late George Fontanills, always used to say:

“You Can Trade Options Naked, But NEVER Trade Naked Options”

Bless his soul…

And today, I’m echoing his words because I am seeing far too many publications that are campaigning for the riskiest strategy in the options world: trading naked options (this is also known as shorting options).

The idea of trading naked options is something that I’m not a fan of at all…even when considering it as a day trade.

In fact, I will NEVER publish a trade that involves naked options.

But it’s important that we talk about them today because as I’ve said countless times before, #1 goal is making money is my #1 goal – and that there is a right way and a wrong way of doing it.

And trading naked options, folks, falls under the “wrong way.”.

The RIGHT way to make money trading options is using safe and effective strategies. This means using strategies that have either minimal risk accompanied by higher-than-average success rates or ones that have favorable risk to reward ratios (or both).

And selling naked options is neither safe nor effective.

Let’s start with the basics to understand why…

Remember that an option is an agreement between you and the markets. When you sell an option “naked,” it means that you don’t actually own the underlying security (the stock). This is also commonly referred to as shorting stock.

When you sell a naked put, you are selling to the markets the right to sell a stock (or “put the stock to you”) at a specific price. Remember that a put is the right, not the obligation, to sell (or “write).

So when you sell an option naked, this means that you do not actually own the stock but are willing to have it sold to you at the strike price for which it sold.

So why sell naked options?

You may hear that, though risky, trading naked options is a means to an unlimited profit potential. And proponents of this strategy may say that it’s a great way profit off of the stock you wanted in the first place.

Now this may be technically true in that you take in the amount of the premium when you sell it and reduce the basis of the stock when you’re forced to buy it…

But you may ultimately be risking much more than you anticipated, despite the amount of the premium that you took in.

Advocates of this strategy will also say that selling naked options is cheaper, and therefore, less risky. However, what this does is actually cause beginner traders to sell more option contracts than they should…increasing their total risk levels.

Let’s look at an example using American International Group, Inc. (NYSE: AIG):


Let’s say a trader wanted to sell a naked put on AIG (expecting the price to move another two points higher) so that he or she can then buy back the put and pocket the difference.

The January 16 $62 put could have been sold at $0.81. In this case, one contract is equivalent to $81. Ten contracts is equivalent to $810.

As you can see, what happened to AIG wasn’t great…


As a result of selling naked put options, the trader was forced into buying shares of AIG at $62. But this means that the seller would then own a stock that is at $57.50…which results in a loss of $4.50 per share.

Now if the trader were to buy the option back to close the obligation (as the seller of the option), the contract that was sold for $0.81 would now need to be bought at the current price of $4.60…netting a loss of $3.79.

And if that trader bought 10 contracts, then the total loss comes out to $3,790 ($4.60 – $0.81 x 1000 shares/10 ctr. = $3,790).

So you can see in this example that the trader’s reward expectation ultimately resulted in an even greater loss.

If that seems scary, then just wait…

This Is the BEST Option for Limited Reward… and Unlimited Risk

There’s something out there that’s EVEN RISKIER than selling naked puts: selling naked calls.

As with selling a naked put option, a trader does not own the underlying stock when selling a naked call. But unlike a naked put, where the seller’s risk is substantial, a naked call seller’s risk is, essentially, unlimited.

Let’s see what can happen to the naked call seller…

If a stock is trading at $50, and a trader sells a naked call (let’s say a Feb. $50 Call for $1.00 for 1 contract or $1,000 for 10 contracts), then the trader is selling the market the right to buy that stock from him or her at $50.

But remember that as a naked call seller, the trader does not actually own the stock to give if the markets exercise the right to buy that stock (or call the stock away from the trader). This means that the trader would then need to buy the stock in the open market at the current market price to replace the $50.

So the unlimited risk here lies in the fact that the stock can go up indefinitely. And I would go even further by saying that the price risk on the stock remains unlimited until the expiration date.

Now, if some favorable news is announced on the stock and boosts the price higher… to the tune of $60 per share… and the call gets exercised, then the trader still takes in a loss of $10 on the stock.

And even with the premium of $1.00, the loss is 9 times that of the premium (a loss of $10 on the stock price offset by $1 for selling the call = a loss of $9 per share).

Furthermore, if the trader decided to buy back the call to close the obligation on 10 contracts, then this would be a whopping $9,000 loss ($1,000 – $10,000 = -$9,000)!

So in conclusion, and as you can see from the examples above, you’re setting yourself up to take on unlimited risk as a naked options trader

And this is exactly what I’m trying to protect you from.

Instead of selling naked options, consider spreads as a better alternative… especially if the cost of buying calls or puts exceeds your risk level.

A spread is created when one option with one strike price is sold to generate a premium while another option at a different strike price is bought to act as a hedge against the option that was sold. Both of these options are to be done simultaneously on the same order ticket, which constitutes one trade.

(Power Profit Trade readers and Money Calendar subscribers also know this strategy as the ‘Loophole Strategy’).

So steer clear of naked options…unless of course, you’re comfortable taking on unlimited risk…

Here’s Your Trading Lesson Summary:

STRATEGY: Avoiding Naked Options

There are publications and so-called experts out there encouraging people to trade naked options to unlock unlimited reward potential. But before even considering this strategy, there are three things you need to know:

  1. You do NOT own the underlying stock
  2. You expose yourself to UNLIMITED RISK
  3. You can use a spread strategy as a safe alternative

And stay tuned for more safe and effective ways to make money – and keep it- in 2016.

Until next time…

Good trading,

Tom

7 Responses to “Traders Beware of this “Options Deathtrap” in 2016”

  2. Dan M.

    Thanks for the good summary of some of the risks associated with options trading. Perhaps “debt-trap” is a better term than “death” trap for selling put options, because once a trader is assigned (put) the underlying stock which he theoretically ‘wants to own’– he can repeatedly sell out-of-the-money call options and exact payments from the investment (or loan) of his stock purchase. Unfortunately this strategy can tie up capital for much longer than he originally planned. But on a long enough timeline this strategy is much better than simply ‘buy and hold’ naked stocks. I like the loop-hole options strategies you employ, combined with the money map calendar timing. The problem I have with it (which isn’t your fault) is that my IRA trading account rules don’t allow selling call options unless I first own the underlying stock. So that forces me to buy the stock before doing a loophole call option trade.

    January 12, 2016 at 8:24 pm
  3. Tom D

    Your IRA can allow Call (and Put) debit and credit spreads. So you needn’t own the stock to sell calls. Spreads have margin required, it’s the difference in price between the long and Short calls since that is the max loss. Depends on your IRA custodian’s policies I suppose but I have two accounts that permit this.

    January 13, 2016 at 2:03 pm
  4. Tom D

    Debit or credit spreads on calls or puts are allowed in IRA’s. So when you own the offsetting option (a spread) the margin is the price difference between the one you bought and the one you sold. No need to own the underlying stock

    January 13, 2016 at 2:07 pm
  5. Steve J

    Tom,
    I think if a trader has decided to buy a stock and has an exit plan of let’s say a 15% stop at the time of entry, if the trader buys 100 shares of a $50 stock, the buyer is out $750 if the stock drops to the stop. On the other hand if the trader sells an at the money put, he might collect $150 in premium for a month of time. During that time, if the stock reaches his stock stop, the put has probably appreciated to something around $4.5 to 5.00, so the trader is out $350 instead of the $750 had he bought the stock outright. If the trader gets assigned the stock and it later reaches his original 15% stop, he is out 750 minus the $150 or $600, which is still better than if the stock had been bought outright.

    It seems to me that selling naked puts reduces the risk of getting into a stock, and reduces the cost basis at the same time. BUT, it’s all about having an exit plan for the put as if it were the stock and then sticking to it. Of course, the trader should never be doing this if he doesn’t intend to own the stock. That’s my two cents.

    January 13, 2016 at 4:45 pm
  6. Tom Gentile

    I know that most limited risk option strategies are allowed in self directed IRAs, but not sure of specifics for each one.

    Steve, you are absolutely right on both points… Naked Puts do allow you a lower cost basis and in a sideways or even slightly falling market, will outperform the stock trader. In a rising market they wont, and what ends up happening is alot of Naked Put Sellers will then try and compensate by using too much leverage and selling more puts than cash allows if assigned, creating unnecessary risk which eventually will catch up with them… like now.

    Good Stuff everyone… keep it up.
    Tom

    January 21, 2016 at 5:48 pm
  7. Mark

    ISelling a naked put is less risky than buying the stock because you can’t lose as much. And if you’re going to use the argument “yes you can–on the upside,” then I would remind you: 1. You can’t go broke taking a profit and; 2. Many backtests have demonstrated similar if not higher returns with naked puts with significantly lower volatility of returns compared to being long the underlying stock.

    August 23, 2016 at 1:40 pm

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