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the potential pitfalls of naked options laid bare.

For investors buying equity options, the future can be reasonably predictable; they may not know what the market is going to do, but they already have a worst-case scenario - the most they can lose is the option premium. They also have the security of knowing they will not have to pay margin calls to brokers. investors who sell call options and own the stock also know the worst-case scenario from the outset.

But this is not the case for naked option sellers - those who do not own the shares or the underlying asset. They face several risks, the most important being that the price of the option may change unexpectedly and the position may lead to an unexpected margin call. When this happens it can mean closing the short position will entail a bigger loss than anticipated.

selling naked options can seem, at first glance, to be a good way to earn a premium, but there can be several unexpected and unpredictable problems during the option's life.

An investor sells a naked call option with a strike price of PS90. if the market rises to PS100 this option will be declared by the buyer of the option, and the investor who has sold the option could face a loss of PS10 per share. in effect he has to give a profitable long position at PS90 to the buyer of the option while receiving an unprofitable short position at PS90.

The investor could also go to the market and close his position by buying a call option with a strike price of PS90 but in this case his loss would be normally about the same.

one of the major problems of selling options is the position can deteriorate very rapidly and margin calls can come thick and fast. options with a strike price that was far from the market when they were sold can quickly become at-the-money as the market moves, catching the investor unawares - a call option with a strike price of PS150 when the market was PS90, for example.

At the outset, this option would not cause the broker too much anxiety as the chances of it being declared are remote, but as the price increases, so would the potential loss. Also, as the market rises towards the option strike price, the option premium changes more quickly; eventually, the premium moves pound for pound in line with the market.

The final major issue to be monitored is time to expiry, which can also entail a nasty surprise. A six-month option will normally cost more than a three-month option - all other factors being equal - and if the market doesn't move, the value of the option decreases as time passes.

What can catch traders out is an option's value can drop dramatically in the final days of its life - good for those who have sold an option and are looking to buy one to close the position but bad for those who have bought options.

even in the best-case scenario, where the option expires leaving the seller to bank the premium, unexpected margin calls can disrupt the strategy during its volatile lifespan. ?

Selling naked options can seem a good way to earn a premium, but there can be unexpected and unpredictable problems

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Title Annotation:Business
Publication:Insider Monthly
Date:Jan 4, 2013
Words:541
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