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Im just starting to get into options and there's one part that I haven't found a discussion on yet.
What happens if I'm the writer of an out of the money naked call and its nearing the expiration day and my options eventually go, or approach, at the money.
My objective would be to earn the premium but given that probability is high that I would be at the losing end of the option what are my "options"? *What would most options traders in that scenario?
1. *Would I have to wait it out until after expiration hope for the best, and then make "delivery"? *As in go in the market and make the purchase of the asset?
2. *Would traders buy a call with a matching strike price to offset the obligation and transfer to the original call holder in the case it goes in the money?
3. *Can traders as writers trade obligations or that option to other traders?
What do options traders do in this scenario? *Lots of literature out there on the upside and strategies but haven't found as much on the downside realities.
Can you help answer these questions from other members on NexusFi?
Well, reality is that discussing losses does not really sell people on the idea of trading options. So if you wish to entice people to subscribe to your service or your brokerage, it helps if you focus only on the winners.
To use an example of risk management, lets assume that you wish to sell an AAPL call since you believe AAPL won't go above 110. Going out on the options chain, I get the following bids according to IB:
Dec 24 2015 - 0.04
Dec 31 2015 - 0.36
Jan 08 2016 - 0.87
Jan 15 2016 - 1.33
Jan 22 2016 - 1.91
Jan 29 2016 - 2.81
So, you could sell any of these options at the bid (bid-ask spread is reasonably close for the 110 calls) and then wait for the trade to mature. Obviously the longer to expiry for the option, the greater the chance it will go in-the-money and thus the greater the chance that you will lose. For simplicity, let's assume you sell the Jan 08 call for 0.87 (with IB's initial margin being $1,972) you receive $87 (before commissions)
Should AAPL stay at 107.23, you get to pocket the $87 per contract. In this scenario, you make money either when AAPL stays where it is, falls, or rises a little. Thus, a lot of potential outcomes lead to a gain.
However, should AAPL rise to 115, then your option goes in the money and at expiration (with AAPL at 115), the 110 call would be worth 5. So you lose $413 per contract. So in order to protect yourself against this, you could do the following (based on your ideas above):
Purchase the stock as soon as it touches 110. Here you change your risk profile. There is no longer any risk on the option, but you are exposed to risk on the stock. Should AAPL fall below 109.13 (110-0.87) you lose money on the trade. However, you still have a large number of scenarios that could play out in your favour.
Purchase another call with the exact strike price. This call could be more expensive that the original you sold. This is determined by the expiration day and the point at which you bought it. In general if AAPL increased in value, the new call will be more expensive and should you buy the call with a later expiry it will be more expensive. It should also be noted that should your short call be called (you need to deliver the shares), exercising the long call could lead to an immediate loss in time value.
Merely close the position, i.e. buy back the call in the market. Yes you will lose some money, but I would prefer this approach to the one where you purchase another option with the same strike.
@SMCJB also mentioned that you could roll the position. In this case, once your position loses a certain amount of money, you could close your short call for a loss and then open another short call at a higher strike (lets say 115). You will lose on the first call, but you will then hope that the second call recoups some or all of that loss. Of course should the market continue higher, then you will continue losing as you roll out further (since you are buying back the short call at a loss).
However, none of these strategies address gap-risk, i.e. what do you do if there a news event and AAPL opens up at 140 (unlikely, but just look how solar stocks performed recently on news). This risk is somewhat lower with futures, but you should review this thread -
The best form of naked options risk management, is don't sell naked options, there is no edge in earning the premium, you will get steam rolled at some point and give it all back, everyone does.
If you must sell premium, do spreads, if that is too complicated for you, don't trade options.
selling naked options is an extreme risk for a poor income, one time that you get caught off guard is enough to kill you, particularly if you dont trade "historically predictable stocks", meaning that you can get a +20% from one day to the other.
That been said I have been selling naked for 20 years, but using ratios, that way you can always adjust the strategy I have recovered positions after moveing 20% against me with no problem.
Another issue es the roll over, buying back the option you sold naked and is a clear looser to sell the next expiration you choose, praying that it will go your way is crazy. If you are so far into loss than closing and asumming the lost is not a real possibility, you are just getting yourself into a major problem of keep betting against an stablished trend
Finally transformation is not the holy grail, when you are in a big loss a transformation will make different your profit to loss ratio but you will be assuming that loss inside a strategy converted in such a bad shape that you are asumming actually the loss internalizing it into the worst strategy ever, one that you wont form in the first place because is impossible to profit
Option trading is an art, and without attacking anyone I cant believe that in this forum strategies are actually meant as buy options of several assets and wait for them to go our way. Sadly most o my videos on the subject are in spanish, but I have an old set of videos explaining a whole expiration of trading stock options
