Insuring Your Naked Options Positions

The mention of the term "naked" selling to any trader will draw out the thoughts of unlimited losses in exchange for a limited profit.  Seemed a bad idea for trading where everyone is looking to make unlimited profit with a limited loss.

This context of naked selling will deal with futures option selling which there is more flexibility in controlling the risk in doing option selling or what they commonly called option writing.

A little background here for the benefit for those who are not very familiar with what option selling is about.  When you sell a call option at a strike price of say $30 against stock ABC for example, you would want the stock price to stay at or below the price of $30 on expiration date so that your call option will expire worthless and you get to pocket the entire premium collected from the sale of the call option.  Similarly, when you sell a put option, you will want the stock price to stay at or above the price of $30 on expiration for the same purpose.  That is to say, the option sold on expiration date must be out-of-the-money (OTM).

Now, the key thing that worries most traders is that for the sale of the call option, what if the price of the stock goes above the strike price of $30?  The damage can be unimaginable if you do not do a proper risk management or insure your naked position.  We want to minimize the damage of such event, though I would love to say that I want to prevent such event, which definitely I can't.

In my website (www.anybodycanberich.com), I have provided for the use for a probability calculator which works out the probability of an underlying expiring above or below a certain level.  You can also find this calculator elsewhere but I have provided it free for your usage.  Simply key in the implied volatility of the underlying, its current level and your target level and the required probabilities will be automatically worked out for you! But of course, this is just statistically, not DEFINITE!

Ok, one example here. I want to sell a put option against the E-minis futures ES at strike price of 800. The current level of ES is at say 966.  Key in the volatility of ES (you can get it from www.ivolatility.com) together with the two numbers mentioned earlier and the days till expiry and bingo!

Now that you have got the probability of it expiring above 800, which is about say 80%, which is pretty high.  To make things even safer, I would want to insure this naked put position.

For my trade, this is what I will do.  I will buy one put option at a strike of say 900 for say $300, sell another put option at a strike of say 850 for $200, both expiring in the same front month.  Notice this is currently a debit trade which I have to fork out money.  But then, I will sell another put option at the strike of 800 (the original strike which I wanted to sell the option) which expires one month later than the earlier options for a premium of say $250.  I now make a net credit of $150 on these trades which comprise of 1 buy option at 900, 1 sell option at 850 and 1 sell option at 800.

How does this protect my naked position at 800 then? 

If ES stays above 900, for sure all my positions will expire worthless. 

But if ES were to approach my naked position at 800, my put option at 900 and 850 would have gone ITM and made me a profit of 50 x $50 before my naked position at 800 gets threatened!

The only thing we do not want is ES coming down furiously to 800.  However, with the probabilities that we worked out earlier, theoretically, even if ES will to reach 800, it should take some time to reach it and by then, much of the time value of the options sold would have decayed and benefited our positions and made us a profit by then.

Hope this article on insuring your naked position in futures option has been helpful to you in doing naked option selling.