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August 10, 1998
Go Naked
Strategy offers big returns, and risks
By Max G. Ansbacher
A dramatically underused options strategy -- the sale of uncovered, or
naked, options -- yielded a return of 93.9% for my clients in 1997. And while
I can't promise such profits in the future, the strategy has produced an average
annual return of 35% for the last seven years.
As the term implies, naked option writing leaves you exposed, in this case to
risk. By selling, or writing, an option, your profit consists of the premium on
the option you've sold. The aim is for that option to expire worthless, so you
pocket all of that premium. The risk is that the option won't expire worthless
and indeed could rise in price. The option writer then would have to buy back
the option, at a higher price, for a loss (since there is no underlying position in
the security to offset the option).
The probability that options actually will expire worthless, however, can be
increased by utilizing two of their unique characteristics:
The first is the wide range of strike prices available. By writing only options
that are far out of the money, you increase the necessary price change in the
underlying security for the option to have any value when it expires, thus
greatly magnifying the odds of profitability.
The second characteristic -- the time until the option's expiration -- also can
increase the likelihood of its expiring worthless. Very short-term options, say
with only a few weeks to run, have a lower probability of moving into the
money because it would take an extraordinary move in the underlying
security.
I take advantage of these two characteristics by writing options that are as far
out of the money as possible, and with as short a life span as possible, yet
with reasonable prices.
Depending upon many variables, including the volatility of the underlying
security and the market price of the option, in about only 10% of instances
will short-term, far-out-of-the-money options be worth anything at expiration.
This means that writing uncovered options theoretically can have a chance of
being profitable 90% of the time. These are good odds to start with.
Some sophisticated options traders obviously buy the very options I choose
to write. They recognize that their probability of winning is low, but they
expect that in the 10% of the times when they do win, they will occasionally
have tremendous profits from "outliers" that will more than offset all their
losers. They may prove to be right. And if they end up making a lot of money,
I will lose a lot of money.
So I have developed a four-point risk-control program to reduce the
possibility of large losses on those 10% of the trades. The first element, as
noted, is to write only short-term, deep-out-of-the-money options.
Second, I strictly limit the number of options that I write for each $100,000 of
equity in the account. This rule is the foundation to limiting one's exposure to
loss; disregarding this is probably the biggest source of problems people have
had with uncovered option writing.
Third, I check the market value of my
options daily to verify the relationship
to value of the account. If the option
prices move up, then my risk has
increased without any action on my
part, and it may become necessary to
reduce that risk by closing out options.
Fourth, and perhaps most important,
is to have a stop-loss order entered on
the floor of the exchange for each
option. Many traders do not want to
tie their hands in advance of any
adverse moves. But the best time to
decide when to exit a position is when you enter it. By placing my stop-loss
orders in advance, I eliminate the chance of making a possibly fatal mistake
later. When things go badly, traders often decide to wait just a few minutes
longer in the hope that things will turn around. And sometimes the traders
never act and things get only worse.
One key attraction of uncovered options writing is that it can be used equally
well in a bear market or a bull market. Who should utilize this strategy? Only
those with money they can afford to lose. As with any risk-capital investment,
when properly managed, the rewards can be handsome indeed.
MAX G. ANSBACHER, chairman of Ansbacher Investment Management in New York
City, is the author of two books on options.
Len |
