After making a name for herself and attracting millions in investor funds, “Karen the Supertrader” allegedly lost $100 Million when volatility spiked in late 2014 and August 2015 and is currently under SEC investigation by attempting to hide/delay losses by rolling positions out to later months. These strategies work in a low volatility environment, but blow up spectacularly when volatility spikes.
I wanted to share this story to stress the amount of risk that naked option selling strategies take and how vulnerable a trader can be when volatility spikes. At Maverick, we always want to prepare for worst case scenarios and there is just no way to quantify “worst case” with a short call or put. If you trade for a long enough period without risk that can be measured, then something will happen that will eventually wipe you out.
The biggest problem with selling naked calls/puts is that a trader only brings in a small amount of premium, but takes on a huge amount of risk. For example, if I brought in $1 (max gain) in premium, but carried $30 in risk, then just one bad trade can wipe out months – even years – of gains. I have never understood why a trader would sell naked options when a spread trade is superior in almost every way.
Here is a side by side example of a naked option vs. a spread trade:
TRADE SCENARIO – Stock is currently trading at $95. Trader does not think that the stock will close or go above $100 within the next month (November).
NAKED OPTION: Sold 10 contracts of the Nov $100 Calls for $1.00
- Margin/Capital Required: $19,000 (typically 20% of the underlying position – premium received)
- Total Potential Profit: $1,000
- Max % Return: +5.2%
- Max Risk: I won’t put unlimited, but let’s say that an unexpected 30% pop/drop happens in the stock (which is very possible), then that would result in a -$12,500 projected loss (though it could be much worse – e.g., if a company gets bought out for a 50%+ stock price premium)
SPREAD TRADE: Sold 10 Contracts of the Nov 100/105 Bear Call Spread for 0.80 (since bought the $105 for 0.20 to hedge)
- Margin/Capital Required: $4,200 since received an $800 credit
- Total Potential Profit: $800
- Max % Return: +19.0%
- Max Risk: Let’s again say that an unexpected 30% pop/drop happens in the stock (which is very possible), then that would result in a -$4,200 loss (which is the max loss possible)
The spread trade is superior in every single way (except for one that I will discuss), which is why I don’t understand why people sell naked calls/puts. With a spread, the return on capital is much better, the margin impact is much lower, the overall risk profile is capped and quantifiable, and you have taken out that chance that something very quick and sharp happens and wipes you out.
Contrast a spread with naked options. I have seen many traders try these low reward/high risk naked strategies. They do well until the one day when the market goes haywire and they take a $50,000 loss. It’s almost impossible to recover from that kind of loss if their typical gains are $500-$1,500 per trade. A $50,000 loss could take years to get back to break-even.
So, the one difference that some traders like to point out to me is that the Bear Call Spread only delivers $800 in potential gains vs. the $1,000 in the Naked Call. However, I think that is a backwards way to look at things. Let’s say that a trader wanted a return of $1,000 on a short call strategy. In our example, that’s easy…simply do the spread for 12 contracts instead of 10 and the trade is still superior.
SUMMARY
I am sending this email out to give anyone trading low reward/high risk (short volatility) strategies a chance to reevaluate their risk parameters and to warn anyone thinking of employing these strategies of the risks. Just do yourself a favor and buy a cheap option for 0.05-0.25 to hedge any short option positions and quantify your max risk. Remember, smart traders want returns for a lifetime…not just until the floor drops. Being paranoid and prepared for worst case scenario is the best way to survive as a long-time trader.
There is a famous saying in the market, “There are old traders and bold traders. But, there are no old, bold traders.”
Thanks for reading my rant,
Robb Reinhold
CEO, Maverick Trading
