Short Options

There are riskier options strategies that seem more like gambling as they can open you up to a significant amount of risk than more traditional options trades, like buying calls and puts. Two of these higher risk strategies are uncovered calls and puts.

And if you want to sell naked options, you’ll be required to have the top level of clearance from your broker, as well as a margin account. Most brokers require a minimum $2,000 balance to maintain a margin account. 

Trading on margin can be a risky proposition. If your losses exceed your account, you still have to pay back the balance. And with short calls and puts that are uncovered, these can accumulate quickly. In fact, your loss potential is theoretically unlimited for naked calls, and extensive until the stock hits $0 for puts.

Let’s take a closer look at these high-risk, low-reward strategies.

Naked Calls

When a trader sells calls, they are making a bearish bet. The position gains value when the stock stays put or declines. 

An uncovered call means you are selling a call on a stock you do not own. The profit potential is capped on the trade at the premium collected, but the risk is not — if the stock price jumps above the strike price, and the call is exercised, you will be responsible for buying the stock on the open market and then selling it at the strike price to cover your portion of the contract.

In other words, you could be subject to heavy losses. 

Let’s say RBLL stock gapped below $10 recently, and you think this round-number level will serve as a short-term ceiling for the stock. You decide to sell a 10-strike call for $3, or $300 (accounting for 100 shares). 

This is also the most you stand to gain on the trade, should the shares remain below the strike through expiration.

However, what happens if the stock gaps sharply higher, and gaps all the way to $30? Losses can accumulate quickly once the option moves into the money. Considering your breakeven price is $13 (strike plus net credit collected) you’d be staring at a loss of $23 (30 – 23), or $2,300. This loss would only grow the higher the stock climbs.

Naked Puts

A short put is also called an uncovered put or naked put, and is initiated by selling a put. Unlike the option buyer, the put seller collects a premium, and this premium represents the maximum potential profit on the trade.

A short put play is neutral to bullish because by selling the put, the trader believes the stock price will remain above the strike price through expiration. If the stock stays above the strike, the option will expire worthless, and the speculator gets to pocket the full premium. However, if the stock price falls below the strike price, the put seller faces significant losses.

Why?

Because the put seller is required to purchase the shares of the underlying stock at the strike price if the put buyer exercises the option. What happens if the company goes bankrupt, and the shares go to zero? Well, those put options would become really expensive.

Take a look at RBLL stock, which has been holding above short-term support near $10. You think this round-number mark will continue to serve as a floor for the shares, so you sell a 10-strike put for $3, or $300 (accounting for 100 shares).

This net credit received is the most the put writer stands to gain on the trade, should RBLL stay above the strike price through expiration. 

What if the stock gaps below support at $10? Losses will accumulate quickly once the option moves into the money. Let’s say RBLL falls all the way down to $2. Considering your breakeven price of $7 (strike price less net credit), you’d be staring at a loss of $5 (7-2), or $500. 

Wrapping Up

Writing options without being hedged is extremely dangerous and you should stray away from it when you’re first learning to trade options. For those that do choose to short uncovered calls and puts, they will need a margin account and clearance from their broker. 

They will also need to choose their strike prices carefully to avoid assignment, and look for higher levels of implied volatility, since this boosts options prices — and in turn, the net credit they collect.

What is Leverage?

Leverage can be a very powerful tool when it comes to trading. If you ask a majority of traders out there, they will agree that leverage is one of the biggest benefits to speculating with options because it gives them more bang for their buck.

Why? 

Because leverage gives a trader the ability to turn relatively small amounts of capital into significant profits. Since options are derivatives and equal to 100 shares of the underlying asset, they’re cheaper to buy — effectively freeing up trading capital to be used elsewhere. 

Let’s take a closer look at how leverage works.

Leverage Using Options

When a trader buys options, it allows them to control a greater amount of the stock than they otherwise could by purchasing the underlying directly.  

Simply, if you had a certain amount of capital to invest, then you could create the opportunity for far higher returns through buying options than you could buying stocks.

Assuming that you had $20,000 to trade, and you wanted to buy Apple (AAPL) shares because you thought they were going to increase in price.  If AAPL was trading at $200, then you could purchase 100 shares for your investment of $20,000.  Now, say the stock increased in value to $225.  You would generate a $25/share profit, or 225-200/200 = 0.125 * 100 = 12.5% return on investment.

Now, let’s assume that you decided to purchase the 200-strike call option on AAPL, and these were being asked at $2.00 each. This means you could pay $200 to buy one contract, which effectively gives you control of 100 shares of Apple — a much smaller upfront investment than if you chose to buy 100 shares of the stock outright. 

Now… This is where it gets even better with the use of leverage.  

Let’s say Apple rises to $225, and that 200-strike call option you purchased at $2.00 per contract is now worth $3.00. This would result in a $1.00 per contract, or $100, gain — or a 50% profit on your initial investment! 

Here is a breakdown of the two trades for your comparison:

Stock:

Capital spent: $20,000

Number of shares: 100

Stock bought: $200

Stock sold: $225

Profit: $25

% profit: 12.50%

Options:

Capital spent: $200

Options bought: 1 contract

Number of shares: 100 share buying power

Options bought: $2.00 / contract x 100 shares = $200 / contract

Options sold: $3.00 / contract x 100 shares = $300 / contract

Profit: $100 / option x 1 contract = $100

% Profit: 50% 

As you can see from the outline above, a trader is able to return 50% of their capital using less money upgront — much larger than the return on investment from just buying the stock outright.  Plus, the stock trader generated a $25 profit compared to the option trader’s $100 gain.  

Wrapping up

The ability to use leverage to multiply your returns is one of most rewarding aspects to trading options over stocks.  And because options are derivatives — effectively controlling 100 shares of the underlying asset — leverage allows traders to reduce their upfront cost, and free up their trading capital to be used elsewhere. 

One of the first things a new options trader should learn is how to read the “Greeks.” While the price of an option is a function of a risk-free interest rate, dividend, strike price, stock price, volatility, and time until expiration, the option Greeks tell us how much each one of these factors plays a role in the option’s price. 

Some of the common Greeks are delta, gamma, theta, and vega. 

So let’s dive into the first option Greek you should know, delta, and see how it impacts your trading.

What is Delta?

Delta measures the sensitivity of an option’s price to movement in the underlying stock. Put another way, delta is the amount an options price is expected to move based on a $1 change in the underlying security.  

Call options have a positive delta that ranges from 0 to 1.0. This means that with each $1 increase in the stock price, the option’s price will increase by the delta amount, with all other factors held constant.  

Put options have a delta that will fall between 0 and -1.0. This negative value indicates that a put option contract will increase in value when the underlying decreases.

For example, let’s say an Apple (AAPL) 200-strike call has a 0.50 delta and is trading at $10.  If AAPL is to rise to $202, the price of the option contract is going to be $11.  Alternatively, if the same contract is traded, but the price drops to $198, the new option contract is going to be valued at $9.  

Note:  It’s important to remember that after the stock moves, delta no longer remains the same value, and will continue to increase toward 1.0 or -1.0 the further in the money the call or put option becomes, respectively.

Using Delta to Choose Your Option

Next, let’s take a look at how choosing an option based on its delta can really boost your profits.

Now, if you expect the price of SPY to rise to $220, you could certainly make an argument to buy any one of these options.

But, it might not be the best trade for you to actually take. Let me explain.

Remember… if the at-the-money SPY 200-strike call option has a delta of 0.50, it will move $0.50 based on every $1 move in the SPY. This means that if the SPY was to move from $200 up to $220, or by $20, through expiration, the value of the option will increase $10.

However, the in-the-money 175-strike call has a delta of 1.0, meaning it will move dollar for dollar with the SPY. In other words, if the SPY was to move from $200 up to $220, the option’s value will increase $20. 

While out-of-the-money or at-the-money options require less capital upfront than an in-the-money option, the higher-probability trade for options buyers is with in-the-money contracts. It’s best to decide which level of risk you’re willing to stomach when choosing your option strike.

Time and Delta

The delta of your option will continuously change based on a number of factors.  One such factor is time until expiration.  As each day passes, an option’s delta will continue to increase or decrease, depending on whether it’s in the money or out of the money.  

If a call option is in the money, every day that draws closer to its expiration date will increase its delta to the maximum of 1.0. An at-the-money call option will typically have a delta of 0.5. Meanwhile, in-the-money put options will have a delta nearing -1.0, and delta on at-the-money put options tends to arrive near -0.5.

If an option is out of the money, its delta will begin to decrease toward its minimum value of 0 every day that gets closer to expiration.

This means that if you are trading an option that is extremely close to expiration and has a delta of 0.10, you would need to have a significant increase in stock price in order for the option to see any significant changes in value.

Delta and Implied Volatility

This is a more complex topic but one that should be understood at the basic level.  

Fundamentally, if a stock experiences a period of higher implied volatility, it is assumed that each strike is going to be easier to reach by the increase in stock movement each day.  Since options are priced based on the likelihood that they will become in the money, the higher this probability, the higher the delta will be for out-of-the-money option contracts.

Alternatively, stocks with a low implied volatility will have higher in-the-money deltas and lower out-of-the-money deltas.  By understanding how implied volatility impacts an option contract, you are able to make a more informed choice when trading options that are best for your strategy.

Delta and the Probability of Being Profitable

Delta is also commonly used for determining the likelihood of an option being in the money at expiration.

For example, if an out-of-the-money call option has a delta of 0.20, it’s said to have a roughly 20% chance of expiring in the money.

By looking at delta this way, it gives the trader a good understanding of the likelihood of the option having value at expiration, if they choose to hold it that long.  

Additionally, this shows the trader that the underlying stock needs to make a massive move in order for that option to be in the money at expiration.  This relationship between delta and the probability of being in the money is why many traders enjoy the benefits of selling options.  

By knowing that a trade has a 20% chance of winning on the long side, an option seller is effectively taking the position of the “house’’ at the casino.  By having these odds working in your favor, this could allow a trader to generate tremendous income potential just by selling options that have an extremely low probability of being in the money at expiration.

Delta and Your Portfolio

Another use of delta is to measure the amount of directional risk your portfolio currently has.  

If you are trading multiple stocks all with positive delta, you will have an overall portfolio of positive delta.  But if you are trading a mixed portfolio of long calls and long puts, you may have a delta that is negative, even though you are bullish on the market direction.

In this case, you are going against the viewpoint you may have, and should consider trading options that will balance the delta or push it in your favor.  For example, if you are bullish, it’s best to have a portfolio that is positive delta, whereas if you are bearish, you would want to have a portfolio that is negative delta.

And in order to maintain a “risk neutral” trading account, a trader would ideally be looking for a combination of puts and calls that result in the portfolio to be as close to zero delta, or “delta neutral,” as possible.

Wrapping Up

When you’re getting into options trading, there’s a lot to learn. Some of the most important factors to understand are the Greeks. Basically, you need to understand how your options will change when the underlying stock moves, as measured by delta, as well as how this is affected by time to expiration and volatility.

At the most basic level, you should understand that:

• Call options have a positive delta, and will increase in value if the underlying stock goes up.
• Put options have a negative delta, and will increase in value if the underlying stock goes down.

Additionally, knowing an option’s delta will allow you to gauge the probability a potential trade will be profitable — and whether or not that’s a risk you’re willing to stomach.