by Nilus Mattive
A few weeks ago, I told you about covered call writing … which is my favorite income-generating options strategy. And in that article, I told you that I absolutely, positively did NOT recommend writing naked calls.
Just as a refresher, the difference between writing a covered call vs. a naked call is simply that in the former case you own the underlying shares you’re writing against whereas a naked call is written without owning the underlying stock.
To understand why writing naked calls is so dangerous, let’s consider a simple example:
XYZ’s stock is trading at $28 a share when you decide to write a call option on it. The option expires two months out, and has a strike price of $35. You sell the contract for $200.
Importantly, you decide not to purchase 100 shares of XYZ nor do you already own them.
A few weeks later, XYZ announces that it’s being acquired by rival ABC for $60!
Now, if you had opted to write a covered call and bought the stock at $28, this wouldn’t be a big deal.
Sure, you’d be kicking yourself as you missed out on roughly $32 a share in upside but that’s the worst thing that would have happened.
Instead, you have literally lost at least $5,800 on your naked call. I say “at least” because there is still additional time left on the contract and the stock could go even higher should a bidding war ensue!
Reason: YOU are responsible for delivering 100 shares of XYZ when the contract is exercised. And that means you have to go out on the open market and buy them at $60 a share. That’s $6,000. Subtract the $200 in premium you collected and you’re down $5,800.
So now you can see why writing naked calls is so dangerous. Your profit is completely capped at the premium you collect while your losses can grow without limit.
Don’t get me wrong. Some people do use this strategy to make money. But they are very adept at writing contracts that will likely expire quickly and without being exercised. Most investors will be best served by avoiding naked call writing altogether.
However, There Is a Different Naked Options Strategy
That I Consider Safe and Effective for Income Generation …
It’s called naked put writing, and it’s like the mirror image of covered call writing. You are basically telling someone that you’d be willing to buy their shares if they fall to a certain level.
The investor buying your “insurance policy” is hedging against potential downside. And as with call writing, you’re collecting a nice premium upfront!
In short, naked put writing is yet another solid way to get income from options trading.
However, the key here is that you must be ready to take ownership of the underlying stock, too!
Like all options contracts, a naked put covers a round lot of stock, or 100 shares.
So let’s say you want to buy 100 shares of XYZ stock, but you think it’s overpriced at today’s level.
Well, instead of placing a good-till-cancelled limit order with your broker — or watching the ticker tape relentlessly for weeks on end — you could write a naked put near your buy price instead.
Then, if the stock falls to that level (or below it), odds are very good that the contract holder will “put” his shares to you. And since you also get to keep the options premium, you’ve actually gotten them a little cheaper than the strike price of the contract!
Alternatively, if the stock doesn’t reach your strike price during the life of the contract, you keep the premium and are free to write another put. Keep pursuing this same strategy and you could really make a lot of money just for waiting around!
There are just a few things to note:
First, you could start off with an immediate paper loss when you take possession of your shares if they’ve fallen below the strike price.
Second, those losses could be substantial if the price implodes.
Third, you must have enough cash in your brokerage account to cover the potential stock purchase under the put contract.
For all these reasons, I consider naked put writing riskier and more aggressive than writing covered calls. But if you’re looking for a way to target specific stocks upon further downside, this approach proves that it isn’t always a bad idea to go naked.
Source: Money and Markets