There are many ways to decide whether to take a trade. If you trade futures, you probably predict price direction, risk and potential reward based on recent chart action. Return on investment probably is not part of the equation.
If you ask a veteran floor trader about the rate of return they are targeting, he’ll likely look at you as if you have two heads. A full-time trader’s objective is to make money, not to compare cash per unit of bankroll through time.
However, the option sellers upstairs can take a longer view. Because trades that depend on time decay take time and require margin, it’s possible to think in terms of potential return on margin invested. And it’s a short step from there to consider the pros and cons of various strategies, such as whether or not to sell options naked.
NAKED? OR NOT?
One common and worthwhile approach to option selling involves capping the unlimited potential risk by buying further out-of-the-money calls and puts, a configuration commonly known as the Iron Condor. However, selling an option naked does not involve protecting your downside.
The idea of a naked trade is to keep all the proceeds of the option sell, using none of them to purchase protective “insurance” further away from the market to prevent disaster. Selling an option naked means leaving the risk uncapped. Purchase of a risk-limiting option costs a commission and diminishes potential reward.
Certainly, many traders prefer this approach. They favor selling the options naked and taking their chances with unlimited risk. They have their reasons. Obviously, spending premium and commissions on options that are essentially designed to expire worthless can seem like a bad idea. These traders are comfortable with their ability to handle the risk in a moving market. Naked option writers sell options far out-of-the-money and if a trade moves against them, they will either cover in the underlying market or roll that option position further out to a safe distance. While this type of risk management can work, it still leaves them vulnerable to overnight event risk.
Traders who elect to sell naked options consider it a financially prudent and confident course of action.
It is akin to not buying fire insurance because there’s no way your house will burn down, at least not tonight.
However, there’s another aspect of this decision that you need to consider: margins.
A PIECE OF THE PIE
Short options have a margin requirement, just like futures positions, because if they expire in the money they will become futures positions.
It’s important to remember the net margin requirement for any out-of-the-money short option will always be less than the margin for the underlying futures contract.
Short option prices change at a lesser pace than the underlying futures, which means less risk and less margin. The short option margin requirement does vary slightly from day-to-day depending upon several factors. The amount of premium collected, distance between the underlying futures price and the short-option strike and any spreading or risk-limiting positions are all evaluated to get a snapshot of the composite risk in any combination of related positions.
This snapshot is taken at least daily by the risk-measuring program called SPAN (Standard Portfolio Analysis of Risk). The resulting margin requirement constitutes a somewhat changeable investment throughout the life of the trade.
THE SIZE OF THE PRIZE
Which would you rather have, an $800 profit on a trade or a 25% annual return overall? Of course, there isn’t enough information provided to make a valid choice and “both” is not an acceptable answer.
The first thing we need to consider is whether the risk is similar. To do that, we need to answer some questions. The $800 is a portion of what annualized rate of return? And 25% of what, anyway? Without enough information to choose, many will make a choice anyway.
Often, they take the bigger payoff, bigger risk and less control. More ominously, most traders gauge their ability to defend the naked position, which trumps the more timid and commission intensive covered approach. However, as we can see in “Risk delayed”, the lower margin requirement of the protected trade is a significant factor in the potential rewards.
THE BOTTOM LINE
“Risk delayed” indicates the trader has a shot at a 40% (or more) return on investment throughout the life of this particular trade (about 105 days). If the underlying July cocoa contract is under the 1700 call strike at expiration, it will expire worthless and the trader will realize that return, assuming there are no position adjustments in the interim. Annualized and compounded, returns in excess of 100% might be attainable.
But the real attention grabber should be the similarity of potential returns for the two types of positions. The first trade, the naked position, has an indicated potential return that is not significantly different from the second trade that features limited risk. It boils down to this: Would you prefer limited or unlimited risk for the same potential return on investment?
And if you’re able to trade at a commission rate less than $35 per option, the difference in returns between the two configurations becomes even flatter and less significant.
NOT CONVINCED?
Option sellers also need to keep in mind the effect of time decay. Time decay takes time. Time is money and you should be compensated for committing your money to risk.
Think of option selling in terms of the classic commercial where the auto mechanic declares, “You can pay me now, or pay me later.” His implication is that if you’re too cheap to pony up for routine maintenance, then you’ll have to dig deep for serious repairs down the road. Selling options is like that. You can cap the risk up front or you can defend your naked shorts after the damage happens.
After-the-fact damage control tends to be inadequate because you’re always playing catch-up. And after-the-fact defense tends to be more commission intensive than limiting the risk from the trade’s inception. So, commissions aren’t saved.
Then, there’s the ultimate consideration: the risk of ruin from sudden, uncontrolled price movement, especially overnight. Any market can be hit with instantaneous, catastrophic volatility. Remember the Asian Contagion? The Sumitomo copper scandal? How about the stock market crash of 1987? Or the problems that almost overwhelmed the bond market when the self-proclaimed geniuses of Long-Term Capital Management bet it all on Black-Scholes? While such moves are infrequent, it only takes one to devastate an account.
On Dec. 23, 2003, traders were thinking about Santa Claus and market conditions were quiet. Live cattle prices had staged a minor rally through the previous sessions and collection of put premium appeared to offer a reasonable return on margin. However, shock struck and after the close the U.S. Department of Agriculture announced that Mad Cow disease had been found in a single animal in Washington state.
Cattle prices went into freefall when the market opened for an abbreviated session on Dec. 24 (see “Cattle crunch”). While the market would plunge for the next five sessions making expanded limit moves the first four days, short naked put holders took the entire hit right away. A modest potential gain instantly became a devastating loss with no opportunity to defend the position by spreading the risk. Such account-killing moves are unusual, but lesser versions of it happen regularly to the peril of any position that carries unlimited risk.
The risk of trading is exciting, but managing risk is not. Is there an upside to selling options naked? Commissions aren’t always saved. Margin requirements are higher for naked positions and potential returns on margin are essentially identical. The primary difference between naked and covered positions is limited or unlimited risk. While it is possible to defend or otherwise manage a naked position after a big move, conservatism would seem to require that you keep your risk capped if you value a good night’s sleep.
Tim Zurick has been selling options since the early 1990s. He advises traders as a broker with Alaron Las Vegas. You can see his trade recommendations at www.commoditycarnival.com.
E-mail him at tzurick@alaron.com.
