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3 Ways to Take a New Look at the Uncovered Call - Is It Really High-Risk?

Posted March 14, 2012

Topics: Finance & Investing

The traditional view of naked call writing is that this is one of the highest-risk strategies possible. But is this necessarily true? Can naked call writing be safer than most of us think? There are ways of looking at risk that challenge traditional thought and even present a scenario for low-risk naked call writing.

Admittedly, this hypothesis is controversial. After all, everyone knows that writing uncovered calls is one of the most reckless strategies around, right? Well, yes, but only if you use the most popular method for defining risk. There are other ways to look at it as well. And as a true-blue conservative investor myself, I challenge everyone to consider a revised definition of high-risk.

The typical risk definition is strategy-specific. So uncovered calls are always high-risk and covered calls are always low-risk. A debit spread is low-risk and a credit spread s high-risk. But there is a big problem with these definitions and blanket assumptions about risk itself. Consider the following:

1. Flaws with attribute-specific definitions. The standard definition of risk based solely on the attributes of a strategy are never universally true. Even on the low-risk side, a poorly structured covered call can be very high-risk.

2. Methods for reducing risks. By applying risk-related standards to selection of an options strategy, you are able to reduce risk substantially. Even for something as high-risk as a naked call, you can make the position low-risk by selection positions with high probability for successful outcome, and timing entry when volatility spikes high. Under these circumstances, even the named call is going to be safer than a covered call entered at the wrong time, with the wrong strike, the wrong expiration, and the wrong probability or volatility.

3. Rethinking the definition of risk for everything. The very idea that a definition of risk may be revised and completely changed is revolutionary. But open-minded traders are going to see the options universe in much different ways if they consider these points.

So for me, a new and changed definition of risk is situation-specific instead of strategy-specific. I have been trading options and writing about them for over 35 years, but this expanded view and definition of risk has made me stop and reconsider the entire question. It simply makes sense. It also presents all of us with a way to approach and define risk based on sensible analytical tools, rather than on assumptions about strategies themselves.

I invite everyone to think about what risk means. As a conservative investor, I require two attributes to make a trade truly conservative: It must reduce risk, but must also increase income. This is not impossible to even paradoxical, as many will think at first glance. But think about it. Any strategy -- any -- will succeed or fail based on timing of entry and exit, with both sides equally crucial. With this in mind, my new definition of risk meets the two-part test (lower risk, higher income), and can be applied to many strategies. Under the traditional definition, a conservative investor must avoid naked options for well-known reasons. But these reasons are based on what I now believe to be a narrow definition of risk.

Michael C. Thomsett (thomsett@conservativetrade.com) is author of FT Press’s “Options Trading for the Conservative Investor.” He is an instructor with the New York Institute of Finance. He teaches five  courses: “Swing Trading with Options,” “The Amazing World of Options,” “Synthetic Options Strategies”, “Options timing and dividend income strategies,” and “Using candlestick reversal and continuation patterns to improve timing.”  He is also an investing and options author and has also written for FT Press’ Agile Investor series, which can be viewed on FTPress.com.