Option selling is a different kind of investing: profit comes not from predicting where the market is going, but where the market will not go over a given time period. And, the naked-option writer, for the possibility of gaining a limited amount of money, takes on an unlimited amount of risk. Is it really worth it for the naked-option seller to submit him or herself to such exposure? Here we explore this question by comparing the selling of naked options on the S&P 500 to limited-risk credit spreads, looking at the difference in SPAN margin needed and the percentage of collected premium to margin needed.

Rationale Behind Going Naked
So, why would anyone write naked options and risk so much for so little? Well, out-of-the-money options have a good probability of expiring worthless, allowing the option seller to keep the premium collected. But, even with the higher probability of profit, the seller of naked options needs to consider the consequences of getting caught if and when the market goes against him or her. (To learn the basics of naked calls, see Naked Call Writing.)

Comparing Naked-Option Writing to Spreads

Here we compare selling naked options to spreads, determining if there are benefits of spreads in reducing risk and achieving higher returns on margin invested. The examples presented below use real SPAN data on the S&P 500 from about the last six months of 2004. The settlement data is from the date shown, and each example involves similar collected premiums. The first example shows a market moving 7% in a 45-day period. The risks involved are indicated. The second example shows a channeling market and compares the returns as a percentage to margin given the 47-day time frame. We use the settlement data as our pricing for entering and exiting the example trades.

November 1, 2004: S&P Settles at 1130
November 1, 2004, Naked Strangle: 6-lot - Dec 1200 call - 1025 put

With the S&P 500 at 1130, the index has been between 1061 and 1162 over the past nine months approximately. Taking this into consideration, we sell options 6.2% above and 9.3% below the market, a December 2004 call at 1200 and a December put at 1025. There are 46 days until expiration. The SPAN data shows that we have collected $7,350 in premiums, less commission and fees, and that the initial margin is $70,875 for the 6-lot. If we take our collected premium and divide it by the initial margin [7,350 / 70,875], we get a 10.4% return on initial margin in 46 days if the options expire worthless, giving us a 6.76% per-month return. (To learn more about making money on a short, see Prices Plunging? Buy A Put!)

November 1, 2004, Spread: 7-lot - Jan 1225 -1250 call spread 1025 -975 put spread

To make a comparison, we sell limited-risk credit spreads above and below the market. We are selling the January 1225 call and limiting our risk by buying the 1250 January call. We are also selling the January 1025 put and buying the 975 put. The above shows that we have collected $8,487 in premium and our initial margin is $20,834. The return on initial margin is 40.7% [8,487/20,834] in 82 days if all the options expire worthless, which is a 14.9% return on margin per month. In this first comparison, the return on margin is higher on spreads than on naked-option selling.

December 15, 2004: S&P Settles at 1204.8
December 15, 2004, Naked Strangle: Dec 1200 call - 1025 put

With two days left to expiration, the naked call options are in-the-money by 4.8 points each, x 6. Margin has increased to $115,980, and the unrealized loss is currently $3,075. The additional capital needed to hold the position is $48,180.

This position has two days left to expiration and needs a 61% increase in capital to support the naked option position. And, it's a toss-up whether the position will expire in or out of the money. This position has changed from a calculated risk to a gamble. The average investor faced with these circumstances would probably close the position and take the loss.

December 15, 2004, Spread: 7-lot - Jan 1225 -1250 call spread 1025 -975 put spread


The January credit-spread position still has 35 days left to expiration. The margin on the spreads has increased to $35,543. We are still out-of-the-money with these spreads from where the S&P is trading. Our unrealized loss is less as well, being only $2,800. Between the increased margin and unrealized loss, we need additional capital of $17,509 from the account, less than half of what we would need to hold the adjusted naked strangles. With these parameters of the spread position, we don't have to feel under the gun to make a quick decision, and we can still adjust the position or close it without pressure.

On December 17, 2004, the S&P settled at 1190.45, enabling the December naked strangles to expire worthless. The return on margin was 6.3% [premium collected / increased initial margin = $7,350 / $115, 980]. If we compare the January credit spreads, the position is worth $7,525, giving us an unrealized profit of $962 in the same time frame. That calculates into a 2.75% return on increased initial margin.

S&P 500 Weekly Chart


S&P 500 in a Sideways Market Now let's compare selling naked-option strangles to spreads on the S&P 500 during a sideways time in the market. For this example we will take the 48 days from August 2, 2004, to September 17, 2004. During that time the market went from a low at approximately 1060 to a high of 1132. On August 2, 2004, the market is approximately 1100.

August 2, 2004, Naked Strangle: 6-lot - Sept 1165 call - 980 put


By selling a 6-lot 1165 call and 980 put naked strangle on the September S&P, we collect $6,300 in premium, and our initial margin is $77,010. The return on initial margin is 8.18% [6300 / 77,010] in 47 days if all the options expire worthless.

August 2. 2004, Spread: 6-lot - Oct 1180 - 1210 call spread 990 - 950 put spread.

Our credit spreads are on the October options of the S&P. We collect $7,875 in premium, less commission and fees, and the margin is $16,725. The return on initial margin is 47% [7,875/16,725] in 76 days if all the options expire worthless. On September 17, 2004, the S&P is at 1127. The naked strangle position expired worthless on both sides, allowing us to keep the entire premium collected. As mentioned before, our return is $6,300, or 8.18%, over the 47 days.

September 17, 2004, Naked Strangle: 6-lot Sept 1165 call - 980 put
September 17, 2004, Spread: 6-lot - Oct 1180 - 1210 call 990 - 950 put

As of September 17, 2004, we have an unrealized profit of $6,450, less commission and fees, on the spreads. On an initial margin of $16,725, that profit translates into a 38.5% return made during the same time frame as the naked strangles. We still have $1,425 in unrealized premium to collect if the spreads expire worthless in the next 28 days. On the current margin of $22,223, that premium would give a return on initial margin of 6.4% in the next 28 days. It is our determination to close the position now, and to re-establish a new position with a higher return on margin invested.

The Bottom Line
The wise investor is juggling to get the best return on his or her investment with the highest probability of profit and the least exposure. As our comparisons of naked option writing and spread strategies show, a little protection sometimes can go a long way.

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