The naked call is probably the highest-risk option strategy of all, right?
Not necessarily.
Most options traders associate risk with specific strategies. But you might want to question this assumption, based on a different definition of risks in trading: risk is not only determined by the attributes of a strategy, but more so by when and where the position is opened.
Even the notorious uncovered call may be less risky than most traders believe, based on a few important observations. These include:
1. Observe volatility for timing the trade. If you open an uncovered call when volatility is exceptionally high, you are likely to get a higher premium as well. The premium is likely to fall in the short term more because of the change in volatility than any other factors, even price movement. This is especially true for calls expiring within one month, when the time decay is accelerated the most. The combined volatility and time decay factors make it very difficult for the option's price to move against you. If you doubt this, ask any trader who has gone long on a high-volatility, soon-to-expire call.
2. Check probability before selling the call. The probability feature will also point you to less risky short call opportunities, again notably those that are short-term and subject to rapid time decay. This could spell the difference between great timing and terrible timing.
3. Don't overlook ITM calls. As counter-intuitive as this seeks, writing ITM options has double potential for profits. First, if you have good technical indication that the underlying is likely to decline (based on probability, for example), an ITM call is going to track point for point when within one month of expiration. Second, if the total premium exceeds the number of ITM points (due to high volatility) then exercise is going to produce a net profit as long as you keep that range in mind. Of course, if the underlying begins moving upward in spite of all indicators, you need to go to steps 4, 5 and 6, below.
4. Cover positions when they move against you. No one gets 100% profits, so you have to know that some positions of all strategies are going to move against you. Cover short calls by stock purchase, or buying a long call to plan for exercise. If the stock price begins moving toward the strike, cover could be accomplished quickly.
5. Cut losses as soon as they start to appear. If you do not want to cover or it is too expensive, know when to fold. Take a small loss today and accept the reality that a portion of your strategies will not work, and then move on to the next one.
6. Roll forward to avoid exercise. The easiest way to avoid exercise is by rolling forward to a later expiration.; But be careful: If part of your theory is to get in and out quickly - like so many traders - the roll extends your exposure and commitment.
7. Watch out for ex-dividend dates. The most likely date of exercise is the last trading day but a close second is ex-dividend date. Other traders exercise ITM calls to time earning the quarterly dividend. A smart exercise avoidance move is to avoid underlyings with ex-dividend date between now and expiration. If the underlying does not pay a dividend, the ex-dividend threat is not a concern.
8. Watch reversal indicators to monitor your positions. Track your reversals as a means for spotting opportunities as well as danger. Beyond the traditional technicals fixed on resistance/support and testing of them, price gaps, and breakouts, also watch for the more reliable candlestick reversals and momentum indicators such as Relative Strength Index (RSI).
9. Convert positions to adjust and recover. Any short call can be converted into a number of spreads or straddles to offset loss. Consider synthetic short stock, the collar, or the simple "covered call" created by buying a long call.
10. Know the risk. This might seem obvious, but so many losses are the result of traders not paying attention to their own exposure. And in options trading, exposure often is created not just by the original open of a position, but by what is done later (for example, closing a profitable long side of a position and overlooking the newly exposed short). Another form of risk to keep in mind is the requirement to maintain collateral in your margin account as long as uncovered short positions remain open; this keeps capital tied up until the short call is closed or exercised. To find out more about collateral requirements, download the free report at CBOE Margin Manual
The various volatility-related signals can be estimated with the free CBOE Options Calculator
Michael Thomsett blogs at the CBOE Options Hub and several other sites. He is author of 11 options books and has been trading options for 35 years. Thomsett Publishing Website
In addition to writing about options, Thomsett also has published extensively on the topic of candlestick charting. You can discover the world of effective chart reading with Profitable Trading Strategies Using Candlestick Charting. This is a comprehensive and complete course on the nature of candlestick charting, offered exclusively by the Global Risk Management Community. By the conclusion of this course, you should be able to locate actionable candlestick signals, better understand what is likely to occur next, and combine candlesticks with other technical signals to forecast price movement. To find out more, go to Using Candlestick Charting
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