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4 Ways to Turn High-Risk Naked Options Strategies into Low-Risk Ones

By  Mar 16, 2012

Topics: Finance & Investing

We have always viewed specific option strategies in terms of risk. Naked contracts, for example, are high-risk. Even basic long options are high-risk because most of them expire, right? Not always. Here is a new and expanded way to look at risk, even for those strategies widely believed to always be high-risk.

1. Consider the timing rather than the attributes of a strategy. A “risky” strategy is only risky if entered at the wrong time. So for example, a naked call opened after a sharp run-up in price including a lot of gapping action, is not as risky as one entered at the bottom. And a naked put is equally safer when entered at the bottom of a sharp downturn. These observations are especially true in two specific cases. First, also look at momentum oscillators and time entry (and exit) for changes in these. Look at MACD and RSI as among the best oscillators revealing when momentum has changed. The second issue is when the price has moved close to resistance (when selling naked calls) or support (for naked puts). These trading range borders are the most likely reversal points in the range. If your timing is confirmed with momentum oscillators, volume spikes, or big gaps challenging resistance or support (or going through it) a reversal is at its most likely point.

2. Base entry and exit on changes in volatility. A particular strategy is not risky just because it exposes you to the possibility of unfavorable price movement. The actual factor making options timing so critical is volatility. So when volatility is high, it is the best time to sell short; and once it falls to a low point, that is the best time to enter a buy to close order.

3. Be aware that proximity and time are the real risk determining factors. Opening a short position for in-the-money strikes or for contracts with a long way to go until expiration does expose you to very high risks. However, time decay accelerates during the last two months of the option’s cycle. So the key to playing the odds is to know when they are in your favor. This is true for contracts expiring in two months or less, at or out of the money.

4. Remember the various escape routes in the underlying moves in the wrong direction. Whenever you sell naked options, you do not have to wait until expiration hoping it ends up out of the money. Once a position approaches or goes in the money, you have several choices to escape exercise. First, you can buy to close. Even if it is in the money, time decay might set up conditions where you can make a profit closing the naked option. Second, you can roll the short position forward, closing it and replacing it with a later-expiring position at the same strike or a higher (for calls) or lower (for puts) strike, reducing the chances of exercise. Third, you can cover the position with stock or with later-expiring or high-strike long options.

The key to all of this is to look at risk from a different point of view. Risk is not an attribute of a particular strategy. It comes about from when and where to accept exposure. So even a short call or put can actually be very conservative if these rules are followed.

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