Today, I wanted to discuss the riskiest Option Trading Strategy known to man. I am going to go through the strategy and then I am going to give you the names of two other strategies that you will want to stay away from because each one of them is using the risky trade within the strategy. So, let’s get started.
The Option Trading Strategy with the highest risk to an investor is known as selling naked calls or short a call. How this strategy works is as follows:
1. You find a stock you think will not have much upside nor volatility, aka SPECULATING. This should be your first indication that this strategy should not be used.
2. You sell a call naked (this means you do not own the stock, but, you are obligating yourself to selling this specific stock sometime in the future at a predetermined price.)
3. You receive a premium (meaning someone is paying you to have the right to buy the underlying stock, that you do not presently own, from you sometime in the future.)
4. Now, this is where this strategy can get UGLY!! READ BELOW
Selling naked calls (short a call) is gambling. You receive a premium from an investor that gives him the right to buy either from the market or from you, whomever is cheaper. Consider the example below.
You sell one (1) naked call on ABC stock at a strike price of $20. The buyer of your naked call pays you $3. (Alright, you just made $3 per contract, or $300.00)*
The current market price of the stock is $15.
Sounds good so far huh? You have $300 and the stock would have to move from $15 to above $23 ($20 strike price plus the $3 premium) before the person holding the call option would come to you and have you buy the stock at the market price and sell it to him for $20. Well, just to let you know, because there is no ceiling on how high the price of the stock can climb, your risk is UNLIMITED!!
Let say you wake up one morning three weeks into the future and find out the stock that was trading at $15 back when you sold the naked call just spiked up $50 per share. Well, guess what, the person that bought the call from you is doing? He is outside banging down your door to get you to sell him the stock at $20, so he can sell it in the market at $65. What an ugly predicament you are in now. You have to buy the stock at $65 and turn around and relinquish it at $20 leaving you with a loss of $42. (Your cost of $65 minus what you sold it for $20 equals $45. But remember, you were already paid $3, so your loss is $43 per share or $4300.00) OUCH!!
Now granted, this is an extreme example, but it is better to just stay away from selling naked calls so you don’t end up on the wrong side of a run away stock while you were sleeping. Get my drift.
Well, hopefully you understand the risk involved in selling naked calls now, here are two other option trading strategies to avoid like the plague:
short straddle: short a call and short a put
short combination: short a call and short a put (combination will have different strike prices, i.e. sell a 20 call and sell a 30 put)
* One (1) contract equals 100 shares of stock, therefore if you receive $3 per contract, you will receive as a premium $300.00.