OPTIONS

“Naked” options writing brings substantial profit potential, but also high risk. Here are ten ways to help mitigate that risk and reap greater rewards when executing this type of strategy.

When it comes to options trading, it doesn't get much sexier than playing it naked. No, I'm not referring to what you wear (or don't) when you're sitting in front of your computer trading (that's your business alone). I'm talking about naked options writing.

While covered options writing ("covering" your option writing risk by owning the underlying stock) is a conservative strategy that offers only part of the benefit of options writing, naked options writing (selling options without the stock covering your position) allows you to reap all of the benefits and profit potential option writing has to offer. It doesn't get much sexier than that, people!

While the potential rewards from writing naked options are outstanding, and the odds of winning are strongly in your favor, there are some substantial risks. In fact, there is unlimited risk when writing naked calls, and extensive risk when writing naked puts—the risk that the underlying stock will move through and far above or below the options strike price.

This highly publicized risk scares many investors away from this strategy, and many naked options writers have lost their shirts (pardon the pun). But although the risk is real, it is usually greatly exaggerated, and if you follow the guidelines I'm about to share with you, you will control that risk and reap the rewards that this game offers.

Set a Bailout Point and Use It

A bailout point is the price, or the point in your strategy, at which you wish to buy back your naked positions in order to limit your losses. This is the point at which you will bite the bullet if things don't go your way, and it is the most important component of your naked option writing strategy. You must use this as a safeguard to limit your losses and control the tremendous risks involved with this strategy.

As an options writer, you have the right to go into the market at any time and buy back your naked options, thereby limiting all possible future losses. Setting a bailout point is a way of insuring that you will use this right when the price hits the parameters you have set.

I strongly recommend using a stop-loss order rather than a mental stop. And it is better to set your stop loss based on the underlying stock's price, as opposed to the option's price, because options prices are more erratic, and in many cases, they may become extremely inflated even though the stock price has not moved accordingly.

Write Naked Calls in Bear Markets; Naked Puts in Bull Markets

This secret of naked option writing is self-explanatory. To improve your probability of winning in this game, it is far wiser to write calls when stock prices in general are moving down and write puts when stock prices are moving up.

This strategy will put the odds in your favor. However, writing naked call options in bull markets can be profitable, as can writing naked puts in bear markets, because of the inherent advantage the naked option writer holds. By following these rules, you will improve your probability of winning the game and reduce some of the risk.

Don't Buck the Trend

Your profits will be much greater in the naked option writing game if you write calls when the underlying stock is moving downward and write puts when the underlying stock is in an uptrend.

The best way to project this type of price behavior is to look at the underlying trend of each of the optionable stocks. Never buck a strong uptrending stock, or in Wall Street parlance, "Don't fight the tape."

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