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Naked strategies

Lesson in Course: Derivatives and options (advanced, 7min)

When writing contracts, what does it mean to write naked positions? When should I consider using this strategy?

Eureka!

What it's about: Understanding the risk involved in implementing a naked call and naked put strategy.

Why it's important: If we choose to short a call or a put, we take on different risks.

Key takeaway: Naked calls result in unlimited risk with limited gains. Naked puts result in nearly unlimited risk with limited gains.

The concept of a naked position is eyebrow-raising and can be quite suggestive. 

The Naked Banana Live Stream - YouTube
 

In the world of options, a naked call or naked put describes an outcome when we write options without having any protection or offsetting positions. An offsetting position satisfies the requirements of assignment.

What is Naked call?

A naked call option is when we sell a call option without owning the underlying.

Selling a naked call

Since a naked put is directionally opposite of a naked call, the requirements for the underlying changes.

What is Naked put?

A naked put is when we sell a put option without owning or short-selling the underlying stock. While brokerages typically don't allow us to short-sell stocks, simply selling put options allows us to write a naked put.

Selling a naked put

The goal for writing naked options is to take payment of the premium from the option buyer and hope the option is never exercised. Let's get our minds out of the gutter and explore the pros and cons of this basic strategy. 

 

Reasons why investors use the strategy

Investors use naked options to accomplish a few goals

  1. Short theta
  2. Option legs for complex strategies
  3. Synthetic option strategies

An advantage to selling a naked call or naked put option is to create negative or short theta positions. We learned that theta decay results in a loss of value over time for an option holder, and also understand that options are zero-sum so thus the seller of the options collects that lost value over time. Combined with the low cost and simplicity of being able to sell a naked option while owning nothing else in our brokerage account, investors use this strategy to capture theta.

Theta generates value for option writers over time 

Naked calls and puts are used as a singular component in multi-option strategies, e.g. a butterfly. Multi-option strategies are complex and won't be covered in the current scope.

Lastly, short option positions are used to create synthetic positions. For example, we can have the economic benefits of owning stock without owning the underlying by combining options.

It's important to note that short naked positions are often used in combination. We'll cover synthetics and advanced spreads like butterflies in future lessons.

Pitfalls to avoid

Naked calls and naked puts expose us to much larger potential losses than if we had just bought call or put options.

Loss can catch us offguard

Naked calls

Naked calls are the riskiest.

Short naked call profit diagram

In the profit diagram above, we can see that the maximum profit is capped at the premium we receive for the option. However, if the stock price starts going up and the call option we sold is now in-the-money, there is no limit to the amount of money we can lose.

We can use an example to help us better understand the risks

 Let's assume we wrote two naked April 2021 $420 strike call options on $TSLA in early November 2020.

$TSLA pice Nov 16, 2020

For the first half of the month, our short call position was doing quite well until the $TSLA share price shot up towards the end of the month.

$TSLA price Dec 8, 2020

On Dec 8, 2020, we would be on the hook for $129,800 to buy 200 shares since the option holder would've most likely exercised the deep in-the-money call option!

$TSLA price Jan 8, 2021

We decide to hold on a bit longer in hopes that the stock price would drop. On Jan 8, the stock continued to hit highs and we now owe our brokerage $176,000! 

 

Naked calls expose us to the risk of huge losses while only offering limited profit. For beginners, using this strategy as a stand-alone is extremely risky and should generally be avoided.

Naked puts

Similar to a naked call, the disadvantage is that naked puts can be very risky with limited potential for profit. However, a naked put is slightly less risky.

Short naked put profit diagram

One major advantage that a naked put has over a naked call is that underlying prices cannot drop below $0. So there is an eventual cap to the amount we can lose with a naked put. You might be thinking, that this payoff diagram looks a lot like the covered-call payoff diagram. This is because a naked put provides the same outcome as a covered call with the same strike price and premium due to put-call parity. 

Introduction to put-call parity

If we revisit the synthetics example above, we can see that we're actually looking at a simple algebraic equation. This equation is the basis for put-call parity and allows us to re-create different synthetics.

Synthetics have the same value as the original
What is Put-call parity?

The pricing relationship that exists between put and call options on the same underlying with the same strike price and maturity date.

A list of possible synthetics
Stock=Call+Short Put
Short Stock=Short Call+ Put
Call= Stock+ Put
Short Call=Short Stock+Short Put
Put=Short Stock+Call
Short Put= Stock+Short Call
Put-call parity example

A short position can be thought of as a negative position.

Call + (-)put = underlying

We can shuffle this equation around to a few different variations, e.g. a (-)put = (-)call + underlying.

Actionable ideas

Starting out, we should avoid naked strategies altogether. If we are looking to get paid when the stock price goes up (naked put), we should just buy a call option. If we are looking to get paid when the stock prices go down (naked call), we should just buy a put option. In both cases our losses are limited, and our potential gains are not capped. Being able to recognize naked calls and puts is important for us to avoid them for now. We will learn in future lessons how to combine naked options with other strategies to improve the risk and reward profile.

 

Glossary

What is Naked put?

A naked put is when we sell a put option without also simultaneously short-selling the underlying stock.

What is Naked call?

When we sell call options without owning the underlying, we are writing naked call options. 

What is Put-call parity?

The pricing relationship that exists between put and call options on the same underlying with the same strike price and maturity date.

  • underlying = call + short put
  • short underlying = short call + put
  • call = underlying + put
  • short call = short underlying + short put
  • put = short underlying + call
  • short put = underlying + short call