In this article we learn that the riskiest option strategies such as the writing of naked options are sometimes employed by professional options traders and hedge fund managers to generate profits on their portfolio. A classic example of this is Karen, the supertrader and options trader/hedge fund manager extraordinaire. It is believed that Karen grew her portfolio from
a small amount to a current amount worth hundreds of millions of dollars.
In a nutshell, you will learn:
– A summary of the risk and reward profile of naked options writing
– Overview of Karen’s options strategies
– How and when professional options trader, Karen, writes/sells naked options to generate a return on their portfolio
– Writing naked options to take advantage of time value decay
– Why it may make sense to write instead of buy options
Risk/Reward profile of naked options writing
The risk and reward profile of naked options writing is a limited profit and an unlimited loss profile. Imagine this. A trader writes a naked call option with the projection that the price of the underlying security stays stagnant or moves lower. The intention of course is to hope that the options expire worthless and when that happens, the trader gets to keep the entire
premium of the option collected.However, if the price of the underlying security increases, he may have to buy to close the option at a higher price. That means that a loss may be incurred.
Theoretically, the price of the underlying security can move up infinitely and the trader can lose an unlimited amount of money. Hence, the general caution. Writing options is very risky.
The charts below will illustrate the risk reward profile of writing naked puts and calls.
<Risk reward profile of naked call option and naked put option>
But does it mean that one should stay away from such options strategies which involve the writing of naked calls and puts? Let us examine that.
Overview of Karen’s option strategies
The last 5 years have been good for Karen Bruton, a professional money manager that operates Hope Investments LLC. The aggregate net asset value of her funds is estimated to be over 100 million as shown in the screenshots below.
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Karen, also known as the supertrader, has generated a fair bit of publicity by appearing on an interview with Tastytrade and openly discussing the options strategies that she uses. She apparently writes naked call options and put options with 56 days to expiration to take advantage of time value decay, that is, theta.
Theta is the rate of decrease in the option premium or value with respect to time. As the option approaches the expiration date, the time value of the option approaches 0 as well. When this happens, the option value or premium will be reduced as well.
Observe the graph above. One should be able to tell that the time value decay gradient is steepest as it is about to reach expiration date. In general, the rate of time value is greatest in the last 60 days of an option’s life.
Most notably, Karen writes naked options on underlying assets such as SPX, NDX and RUT.
Technical analysis
It is believed by many options traders that Karen uses bollinger bands and and other technical indicators to determine her entry points into the market. At points of major supports, Karen will write out of the money put options. At points of major resistances, Karen will write out of the money call options.
Read : Support & Resistance
Out of the money options and probability of expiring worthless
She writes out of the money call options. The naked call options have a 10% probability of ending up in the money.
When she writes put options, she writes puts with a 5% probability of ending up in the money.
Bias towards writing naked puts
Karen is reported to have a bias towards the number of put option contracts in her portfolio. In fact, her portfolio has a greater quantity of put option contracts versus the quantity of call option contracts. The reason for this is that the probability of her put options expiring worthless is estimated to be 95%. This also means that the probability of the put options ending up in the money is 5%. Compared to the call options in her portfolio, the probability of the call options have a 90% chance of expiring worthless. In a nutshell, the probability of her put options expiring worthless is greater than the probability of the call options expiring worthless.
Read: Naked Put: Write An Uncovered Put – Bullish
Money management
In terms of money management, she utilises up to 80% of her portfolio’s capital. In normalised conditions, she uses up to 50% of her portfolio’s capital. One of the justifications for this is that since she shorts or writes options when implied volatility levels are rich/high, her breakeven points are wider. As such, she has a greater price range over which her underlying assets are allowed to trade. This makes most of her trades profitable.
Read: Intelligent money management strategies for option traders
Why selling/writing options may make more sense than buying options?
In statistics compiled from the CME over a period of three years, it is notable that 3 quarters of all options held to the expiration date expire worthless. That necessarily means that buyers of options lose money most of the time. This also means that sellers of options earn profits most of the time. While naked options writing are labelled as an “unlimited risk and limited profit” strategy, the above statistic does paint a different picture in that naked options writers are the ones that make the most profits.