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Options Trading: Are Uncovered Positions Always High Risk?

Posted June 12, 2012

Topics: Finance & Investing

Options traders have been cautioned from the beginning that uncovered options are always high-risk. But this belief should be challenged. It's not the nature of a strategy, but when it is opened or closed that determines risk.

Uncovered calls are risky because an underlying price may rise, in theory, indefinitely. In comparison, an uncovered put can only decline so far. The actual risk level is not zero, but the underlying's tangible book value (minus the premium received when the put was sold).

The distinction goes further, too. For either uncovered calls or puts, risk is determined by:

1. Moneyness. Selling out-of-the-money (OTM) positions provides a cushion against future exercise. As long as the options remains OTM, it will never get exercised. As long as expiration will occur in the near future (within two months) the rate of time decay will be accelerated. This means that time decay will likely outpace intrinsic value even if the position goes in-the-money (ITM).

2. Expiration. Focus on options expiring in the near future (no more than two months out). This reduces the likelihood that the value will increase as expiration nears.

3. Ability to close or roll. If the underlying begins moving against the position, close it out and take a small profit; or roll it forward to a later expiration.

4. Implied volatility. Use one of the dozens of online volatility calculators to time entry and exit based on volatility levels. This is one of the best ways to improve your outcomes using short options.

5. Probability. Also focus on positions with an 80% or higher chance of remaining OTM. If probability begins to decline, close or roll.

6. Realistic exercise policy. No option will be exercised as long as it remains OTM. Even ITM options are only likely to get exercised on or right before ex-dividend date, as someone else will want to earn the dividend. Otherwise, an ITM option is probably going to get exercised on the last trading day but not before. Exercise can occur at any time, but why pay the strike early if you still have the right to the stock at the same price later on?

Selling short calls and puts generates cash and high yields. As long as you keep an eye on positions and accept the risks, mitigating them by ensuring your options stay OTM, your rate of profitable outcomes is going to be vastly improved.