10 Other Ways to Look at Naked Calls

04/05/2013 8:00 am EST

Focus: OPTIONS

The uncovered call is probably the highest-risk option strategy of all, right? Not necessarily, writes Michael Thomsett of ThomsettOptions.com.

I have to admit that for most of the 35 years that I have been trading options, I always associated risk with specific strategies. But recently I have begun questioning this assumption, and I have come to a profound realization: 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. Volatility points to timing. 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.

3. Don’t overlook ITM calls. As counter-intuitive as this seems, 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 of begins moving toward the strike, cover could be accomplished quickly. If only a short time, say only four days remain to expiration, it means all of the value (all time value) is likely to fall even if and when the underlying price rises.

NEXT PAGE: 5 Tips for Naked Call Writing

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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. Neither Amazon (AMZN) or Google (GOOG) pay dividends, so the ex-dividend threat is not a concern with stocks like these.

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).

Also remember that when you open uncovered options, the margin collateral requirement is high, equal to the strike value of the position. If you have funds in your account already, this is not a problem even though it limits the extent of your uncovered option activity. But if you do not have those funds, you need to be aware of this rule. A 50 strike short call requires $5,000 in collateral.

By Michael Thomsett of ThomsettOptions.com

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