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We Have A Winner………

Occasionally I get sent a link to an article that is misguided that it deserves attention. I recently got sent this link – When its actually okay to go naked

I will save you the trouble of reading it by selecting the bits I like the best.

To understand why writing naked calls is so dangerous, let’s consider a simple example:

XYZ’s stock is trading at $28 a share when you decide to write a call option on it. The option expires two months out, and has a strike price of $35. You sell the contract for $200.

Importantly, you decide not to purchase 100 shares of XYZ nor do you already own them.

A few weeks later, XYZ announces that it’s being acquired by rival ABC for $60!

Fair enough you say – that is one of the risks of writing naked calls. After all option writers eat like birds and shit like elephants. However, it is simply a strategy that traders can pursue when appropriate. Option writing is the staple of the volatility trader. So there is nothing remarkable in this statement.

The author concludes by saying

Don’t get me wrong. Some people do use this strategy to make money. But they are very adept at writing contracts that will likely expire quickly and without being exercised. Most investors will be best served by avoiding naked call writing altogether.

Yep – so what? This statement is nothing  other than  a few basic homilies with nothing new added to the notion of trading. But as they say on the idiot box ……….but wait there’s more. The author then goes onto to make the following pronouncement.

However, There Is a Different Naked Options Strategy
That I Consider Safe and Effective for Income Generation …

It’s called naked put writing, and it’s like the mirror image of covered call writing. You are basically telling someone that you’d be willing to buy their shares if they fall to a certain level.

This is one of those things that I had to read more than once – much like the time I
learnt that there was a Jewish community in China. It is one of those things that make your facelook like a labrador does when it has heard a strange noise.

As far as ideas to wipe yourself out this is a good one since it neglects a basic market dynamic – prices fall far faster than they rise. They do this because of an imbalance in investor emotion. Greed is a culturally acquired emotion – it takes time for prices to rise. Whereas, fear is hard wired into us. If you had undertaken this idea at the time of the GFC you would have been pole axed by the market.

In an act of what could be called naive bravado the author recommends that –

Well, instead of placing a good-till-cancelled limit order with your broker — or watching the ticker tape relentlessly for weeks on end — you could write a naked put near your buy price instead.

That’s right – dont worry about manage a contingent liability just let it happen.

Then, if the stock falls to that level (or below it), odds are very good that the contract holder will “put” his shares to you.

I would say the odds of you getting the stock are not only very good but inevitable and there is nothing you can do about it was the process of being assigned begins.

And since you also get to keep the options premium, you’ve actually gotten them a little cheaper than the strike price of the contract!

How jolly sounding is that…..I would suggest you are going to get them a lot lower than you expected. Get it right once or twice and you feel like a hero – get it wrong once and you are screwed.

We do however get some fudging at the end.

There are just a few things to note:

First, you could start off with an immediate paper loss when you take possession of your shares if they’ve fallen below the strike price.

Second, those losses could be substantial if the price implodes.

Third, you must have enough cash in your brokerage account to cover the potential stock purchase under the put contract.

Well if the stock has dropped to the point where someone will exercise their put its a bit obvious that you will most likely start with a loss. You might also end up with a share that is worthless.

For all these reasons, I consider naked put writing riskier and more aggressive than writing covered calls. But if you’re looking for a way to target specific stocks upon further downside, this approach proves that it isn’t always a bad idea to go naked.

Hang on…….I thought you said that put writing was the mirror image of covered call writing so why would you consider it more riskier if it is the same.  If you actually want to know writing covered calls and writing puts are functionally the same – they have an identical payoff diagram and if the author if this article has actually traded options he would understand that.

The thing that really annoys me is that this sort of drivel is picked up by ordinary investors who then trot off to their broker convinced that writing naked outs is safe. And when their broker asks them whether they understand the risks they will go…..yeah how hard could it be. Then when it does go tits up as it will it is somehow the brokers fault. Admittedly some brokers are peanuts but to be dragged over the coals for something that someone has read and then misunderstood because the author really had not idea of the consequences of what they recommending gets on my quince.

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