How to Avoid the Market’s Most Dangerous Game

Selling Naked Options Could Leave You Flat Broke… But Credit Spreads Won’t

A very popular method high-risk traders are using is selling stocks without owning the stock first.  This is called selling naked options because you’re “naked” the stock when selling it. Traders do this when they believe a stock is going to go down in price. For example, if they sense a stock that’s trading at $30 is overvalued (or is going to roll over from a resistance level), they can sell the stock at $30 right now.

Then, the brokerage firm borrows that stock from one of its various accounts and lets them sell those shares. Eventually, traders will need to buy those shares back in order to replace the shares they borrowed. This is called “buying to cover” that stock.

Now if the stock pays a dividend while traders are short the stock, they’re responsible for the payment of that dividend amount. And if the account from which the shares were borrowed wishes to then sell those shares back to them, they’d have to buy it back to cover their short positions. The goal here is to buy to cover at a lower price in order to pocket the difference. As an example, they sell the stock short at $30, and the stock dropped to $25. So they buy to cover the stock at $25 and pocket the $5 difference (less fees and commissions).

No matter what you may have heard, this moneymaking method is extremely risky. Furthermore, there’s a much safer alternative. But in order to show you why it’s better – and discourage you from selling naked options – we’re going to revisit naked calls and naked puts first.

Selling Naked Calls

When you sell naked calls, you’re selling the right to the markets to “call away” the stock from you. This simply means buying the stock at a specific price on or before expiration.

You might consider this strategy when you’re expecting a drop in the stock’s price. But instead of selling the stock short, you’d sell a call option. Let’s say that you sold the same $30 strike option as the previous example. The goal is for you to sell the call option naked, say for $2.00 (or $200 since one contract equals 100 shares) and see the stock fall under the strike price so no one would want to buy it at that higher strike price.

Then, the option either expires worthless, leaving you with the full premium from selling it, or you buy back the option at a lower price, pocketing the difference.

But the risk in selling short the stock is theoretically unlimited – despite what other “gurus” may have told you. If the stock moves higher, the markets may call away your stock at the strike price at which you sold the option. In this example, you’d have to go and buy the stock at the current market price in order to replace or sell it at the strike price of $30. So if the stock you sold short at $30 skyrockets to $1 million per share, you have to buy the shares at $1 million each to then sell it at $30. OUCH!

While you take in the premium on the $30 call you sold in this case, you still have to buy the stock back at $1 million per share. And even though this example may sound a bit dramatic with the stock soaring to $1 million, the point is that there’s no limit to how high the stock could actually go. But there IS a limit to how much money you can take in. And that’s exactly why selling naked calls is deemed by many to be the riskiest trading strategy that exists.

Now let’s take a look at the put side of selling naked options…

Selling Naked Puts

When you sell naked puts, you’re selling the right to the markets to “put the stock” to you, or making you buy the stock at the strike price at which you sold the option.

You might consider this strategy when you’re expecting a pop in the stock’s price. The hope here is that when the stock goes above the strike price, no one would ever want to put it to you (sell it) at that lower strike price amount. And when that happens, the option expires, leaving you with the fill premium. Or, when the stock goes higher, the value of the option depreciates. So you buy the stock back at the lower price, pocketing the difference. For example, say you sell a $30 put, meaning you’ve sold the right to the markets to put the stock to you (make you buy the stock) at $30 on or before expiration.

But say the stock then ends up falling to $20… The markets can now force you to buy the stock at $30, and the best you can do is sell it at $20, leaving you with a $10 loss (or $1,000 since one contract equals 100 shares). Even with the premium you took in offsetting that loss, it’s still not good loss to take.

Now, the risk in this situation isn’t necessarily unlimited, but it’s certainly high enough in that the stock could go to zero, forcing you to buy it at the strike price at which you sold the option – in this case, $30. Remember, a single options contract equals 100 shares, so you’re looking at buying the stock for $3,000 ($30 times 100 shares). And even with that premium you took in, the loss is substantial. And this case just shows what could happen if the stock dropped down to $20… imagine if it dropped down to zero.

I know there’s a LOT of information floating around online about how the profit potential outweighs the risk involved with selling naked calls and naked puts. But when you look at actual examples of what could happen, you have to ask yourself if the the risks are ultimately worth the rewards.

Personally, I say they’re not.

That said… there is a way to sell options WITHOUT selling them naked. And this strategy can provide income – without the risks involved with selling naked options.

How the Credit Spread Can Boost Your Profits and Minimize Your Risk

A credit spread is a sell strategy, but due to the way in which it’s constructed, it eliminates the naked part of selling. It involves selling an option while simultaneously buying another option on the same order ticket (meaning it’s all one trade).

A credit spread reduces your risk by capping your profit potential. Remember, less risk means less reward. But you can still boost your weekly, monthly, and yearly profits even though your profit potential is capped. And putting a max on your profitability for a higher probability of successful trades is just fine by me.  And once I show you the benefits, you may agree…

Let’s look at the put credit spread (AKA the bull put spread).

You’d use a put credit spread when you expect a stock to move higher in price, or at the very least, to stay right around the price at which it’s currently trading.

As I mentioned, you’d need to buy a put option at one strike price and expiration while simultaneously selling another at a different, higher strike price to create a put credit spread. However, you’d need to make sure both options have the same expiration date and the same underlying stock.

When using puts, the higher of the two strikes is going to be the more expensive option. When you buy the put with the lower strike price and sell the put with the higher strike price, you end up with a credit to your account. That credit (or a portion of it) is yours to keep once you either close the trade or the trade expires. As you can see, you’re still selling a put option in this scenario… BUT it’s not considered a naked put sale because you’ve hedged it by purchasing another put option.

The goal here is for the stock to stay above the strike price of the option you sold so that no one will exercise the right to that stock at that lower price, which means you wouldn’t have to (or want to) want to exercise your right on the put you bought. If this happens, then both options expire worthless, and you keep the premium.

Here’s an example of how this works using Valeant Pharmaceuticals International, Inc. (NYSE: VRX):

Say you believe VRX is going to increase a bit in price, so you create a $1-wide put credit spread on it. As you can see above, you’re selling-to-open the $26 put while simultaneously buying-to-open the $25 put. This means that the markets have the right to “put” the stock to you at $26, and you have the right to “put” the same stock to the markets at $25 any time before expiration.

The credit you bring in from creating the spread at the prices shown above would be $0.50 (or $50) per contract. This also the maximum profit you can make per contract, which is a potential 100% rate of return.

The credit you brought in to your account by doing so if you got the prices shown would have been $0.50 or $50 per contract.  If the max profit you can make is $0.50 on a cost of $0.50 that is a potential 100% rate of return, as you see below:

To realize your maximum profit, the stock needs to move above the strike price of the option you sold ($26) and be there at expiration so that way both options expire, leaving you with the credit you took in when you opened the trade.

Now your maximum risk is also $0.50 (or $50). Here’s why…

Say the stock moves to $23. The markets could exercise the $26 put, meaning you’d be forced to buy the stock at $26. And although the stock is at $23, you’re not stuck with a $3 loss because you bough the right to put the stock to the markets at $25.

That’s only a $1 (or $100) difference per contract, which is offset by the $0.50 (or $50) credit you took in per contract ($1.00 minus $0.50 is only a $0.50 loss, or $50 loss).

With a call credit spread (AKA the bear call spread), it’s just the opposite. Here, you’d buy a call option at a higher strike and sell another call option at a lower strike to generate a credit to your account. In the case of a call credit spread, you need the stock to move below the strike price of the call option you sold and stay there at expiration so that both options expire. That way, both options will expire, and you’ll get to keep the credit.

You Can Trade Options Naked, But Never Trade Naked Options

Whether you opt for trading a put credit spread or a call credit spread, you can set it up to where you simply need the stock to remain at the price at which it’s currently trading and be there at expiration so that both options expire worthless – giving you the full premium.

In both cases, you’re creating a credit spread based on what you think the stock WIL NOT do. So if you create a put credit spread, you believe that the stock will not be under the strike price for the option you sold. If you create a call credit spread, you believe that the stock will not be above the strike price for the option you sold. And in either instance, you’re further increasing your probability that the trade will work – without the risks of selling naked options.

My best friend and trading partner who is no longer with us, George Fontanils, always said, “you can trade options naked, but I would never trade naked options.” God rest his soul. And after seeing the risks of selling naked options, I hope you can agree with him.

Remember that there’s an alternative way to create a hedged position that can yield high profits WITHOUT the naked risk…

And it’s called the credit spread.