You Can Win This "Money Game" 80% of the Time (If You Play It Right)

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There are a number of reasons "options selling" is so popular right now. The biggest one, of course, is the money.

You can generate a ton of cash selling naked puts and calls. And you get the money right up front.

Another reason so many people are using this strategy is that you're only "on the hook" for a fixed – and often very short – amount of time.  You can sell contracts that expire in as little as a week now. So if everything goes right, you're out of the trade quickly, and the brand-new cash in your account is yours to keep.

What's more, you can win this "money game" nearly 80% of the time (if it's played correctly).

You can see the appeal.

Of course, when you know what happens the other 20% of the time, you'll also see the risks. They're not small.

That's why I want to show you four ways to make this strategy work.

It's just too good to avoid altogether…

Four Ways to "Write" Like a Pro

Writing naked options is a strategy that works the majority of the time. Again, when you do it right, you can make a winning trade about 80% of the time.

The problem is, of course, the 20% of the time the option can move against you.

In many cases, when you write a naked option and the trade goes in the opposite direction, the losses can be severe. This is because extreme price movements – known as "fat tails" in statistics – happen more frequently than a normal bell-shaped curve distribution would suggest.

For example, extreme short-term moves such as the stock market crash of 1987, the 1997 market meltdown, the 2001 post-9/11 market crash, and the 2010 "flash crash" are supposedly as frequent as a 100-year flood. They've actually taken place every five to 10 years.

These infrequent, sudden, and often violent fat-tail moves can cause explosive price movements in an underlying security, and if you have a naked option that is positioned in the opposite direction, then this can cause significant losses for naked option sellers.

Because of the potential risk of big losses that exists when selling naked options (puts or calls), you need to ensure you are properly compensated for the risk you're taking.

So here's what to do…

1. Get the Price You Want

First, make sure you get the "right" price for your option – the price you want, in other words.

Prices, of course, are set by the exchange. But you can control the conditions of your trade. Using limit orders, for example, will prevent you from accepting an "unacceptable" price.

2. Put the Risk-to-Reward Ratio in Your Favor

Next, make sure you have insight on both market direction and volatility when selling naked options. That requires some tools.

For example, let's say you are selling naked options on a major market index such as the S&P 500 ($SPX). You suspect the market will go a certain way, and you've sold either a naked put or a naked call to collect the premium, hoping that the options stay out of the money.

You then need to check market volatility at the time you write the option. This is easy when writing options on the S&P 500, as we can turn to the VIX.

The VIX is the ticker symbol for the Chicago Board Options Exchange Market Volatility Index (VIX), a popular measure of the implied volatility on S&P 500 Index options. Often referred to as the "fear gauge" or "fear index," the VIX is one measure of the expectation of stock market volatility over the next 30-day period.

Interestingly, the VIX usually has an inverse relationship with the market. That means that volatility rises when the market sells off, and the volatility drops when stocks rally.

The VIX has typically traded between a low of around 10 and a high of 80 over the past two decades. It vaulted to 80 during the global financial crisis of 2008-2009, which was an outlier. Many naked put sellers with poor risk control saw their accounts wiped out during the Crisis. More commonly, the VIX has seen periods of big spikes over 40 on five other big sell-offs, the most recent at the height of the 2011 European financial crisis.  

Take a look at this chart…

As you can see, over the past 12 months we've seen five substantive moves higher and five moves downward. And although this looks like a lot of fluctuation, most of the time the VIX has traded in a relatively tight range between 13 and 16.

The way I use the VIX is to put that risk/reward equation firmly in my favor when writing naked options.  If I'm bullish, I usually won't consider selling naked put options on the S&P 500 unless the VIX is at least 20. It's at this level I know that at least I'm getting paid to take on risk.

3. Limit Your Leverage

One of the best ways I've found to control downside risk is to control the size of your option positions. That means limiting the amount of leverage in your account.

It also means not putting up additional money if you receive a margin call.

4. Cut Your Losses Early… When They're Small

Another risk-control strategy when selling naked options is placing a stop order on the underlying stock. This effectively converts the naked position into a covered option position, under the right circumstances.

For example…

If a trader were to sell naked call options on Apple (AAPL),  they can place a buy stop in Apple stock once the share price goes up to a certain level. This would convert the naked call into a covered call, and thereby reduce the risk of loss associated with writing a naked call.

Another strategy is to cut losses by buying the option back, and then effectively exiting the position. This isn't very efficient, but it is a way to get out of a losing trade before things get worse.

Next: My Favorite Kind of Money

Join the conversation. Click here to jump to comments…

  1. Curtis Edmark | December 11, 2013

    Insurance companies use this strategy to help finance certain fixed insurance products.

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