Subtle Short

Selling naked calls is a subtle way to short in a bear market.

Stock Market

Hedging Naked Calls with Stocks

You sell a naked call on a stock trading at 50 for a 45-day April call at strike price 65. The stock price starts to shoot up immediately and half way to April expiration, the stock price is already at 60, and naturally your call price is way under water. So you start to hedge with 25 shares of the stock. You add 50s shares at 62 and then the final 25 shares at 64.50, so now your naked call is covered.

But the stock price continues to move much higher, all the way to 75 a week before expiration. Now the 100 shares are showing a nice profit, but you need them to cover the April 65 call at expiration. But do you?

What if you rolled the April call at 65 all the way to the LEAPS 85 call at break even on the roll. That gives you a new 10 dollar leeway on this new naked call at 85, which you would again hedge by buying the stock, if need be. Although this tactic creates a lot of time exposure, if you do it, it would allow you to sell your 100 shares and take the profit ($1287) on the stock now that the price has sharply risen to 75, and it may be that the new naked call way up at the lofty price at 85 is a bridge too far for the stock to ever reach, despite the 8-month exposure, given its recent sharp rise.

Would you take that bet? You don’t get paid for not taking risk. If you don’t take the bet, you forgo the $1287 profit on the 100 shares, and merely walk away with the premium on the 65 call after the shares are called away — comparatively little to show for your trade, although now you are risk free, which is a positive. But if you do take the bet, you get the $1287, and if the stock fails to reach 85, you get to keep the premium as well — or the same scenario may play out on the 85 naked call.

Covering Naked Calls

Covering Naked Calls

You can cover your naked call by buying into the stock as it approaches the strike price. If you do this deftly, you then want the stock to be called away as you will make a gain on the sale of the stock. Buy 25 shares first, then leg into the remaining 75 shares as the stock price closes on the strike price.

If you want to be sure that the stock is called away, you can buy the last 25 shares when the stock price is far into the money — you take a small loss on those 25 shares but have gains on the purchase of the first 75 shares below the strike price. This strategy ensures that the stock will be called away — you don’t want to be stuck with 100 share of an overpriced stock.

The awkward situation is when you buy that first 25 shares below the strike price, but then the stock price reverses down hard — now you are stuck with 25 shares on a declining stock. If it declines far enough and hard enough, I start to think about a naked put, which would complete the strangle.

Not crazy about rolling the naked call to a higher and later strike price as you do this with a loss for the first naked call. Hedging by buying the stock means that you get to keep all of the original premium and can even make a small gain on the sale of the stock at the strike price to boot — a win/win. But you must have the cash reserve to do this.

The risk of hedging by buying the stock is that you may be stuck with 100 shares of an overpriced stock because it didn’t hold the strike price. But you have multiple options then. Just sell it immediately for probably a small gain. Sell an in-the-money call for some downside protection if you are bearish on the stock. Or sell another out of the money call if you are bullish on the stock. There are always options with options.

When the Music Stops

Two-Step Strangles

Don’t buy both legs of the strangle at the same time. Whichever side is getting the most stress and therefore volatility, buy that side first. Then wait for mean reversion, and when mean reversion takes place sufficiently, then buy the other side, as its volatility will then be increasing — but wait for a sufficient increase.

Traders who buy both sides of the strangle at the same time are not taking maximum advantage of volatility. If the target asset is going down hard, then the bullish side will have low volatility, so buying the bullish side simultaneously is not optimal. If the target asset is rising sharply, then the bearish side will have low volatility, so buying the bearish side simultaneously is not optimal. If the target asset is not moving much in either direction, neither side will have optimal volatility. So it is NEVER advantageous to buy both sides of the strangle at the same time.

Whichever side you buy first, leg into it instead of buying all the contracts for that side at the same time. If your contract size is, for instance, 2 contracts for each leg, then buy 1 contract first and if the target asset continues in the same direction, buy the second contract at a better strike price than the first. Do the same thing for the other leg. Don’t kid yourself that you “know” how severe a move the target asset will make in either direction. You don’t, no one does.

Naked Calls

Naked Calls

If you sell a naked call and the stock price moves against it, buy the shares before the strike price is reached, and sell another naked call at a new and higher strike price. You need adequate amounts of a cash position to cover all your naked calls with such stock buys. If you buy the 100 shares before the strike price is reached, you then want it to be reached, as this will make for a small gain on the sale of the stock and will also free you of it.

The big risk here is a gap up in stock price that goes well past the strike price, preventing you from buying the stock at a price below the strike price. Quarterly earnings or a takeover bid or some other unusual event can cause such a gap up. You might consider rolling the losing call out and up to get it closer to the higher price of the stock if you think this rise in the stock price is not going to be sustained. If you do think the stock price will be sustained and may well rise even higher, then take the loss and buy back the losing call — some losses are inevitable and are therefore part of the cost of trading options.

The other risk is if you buy the 100 shares before the strike price is reached, and then the stock price collapses — so you are left with 100s shares going into the red. If the stock price drops precipitously enough, but you consider this a normal and reasonable correction, consider selling a put to collect premium and establish a strangle. The premium on the sale of the put will lower your average cost of the stock.

Paul Morphy’s Games