Are Naked Options Positions Truly Unlimited Risk?
Are Naked Options Positions Truly Unlimited Risk?
Learn how to estimate max loss on a naked position.
- The biggest enemy to the OTM premium seller is the big outlier move in the market.
- While undefined-risk positions always have no theoretical cap on potential losses, the maximum practical losses on these strategies can be approximated.
- Using the BPR required by the brokerage to hold the position, you have a reasonable estimate of what the worst-case scenario will likely look like.
As out-of-the-money (OTM) premium sellers, our arch nemesis is the outlier move. The longer we can avoid the big move against us, the better off we are going to be.
Still, if you trade long enough and sell enough options, you are certainly going to run into some two, three, or four standard-deviation moves against you. At some level, that’s just the cost of doing business.
But is there a way to know, at least roughly, the potential size of these moves before they happen? At trade entry perhaps? Yes, there is.
Even though naked positions have theoretically unlimited risk, using a combination of buying power reduction (BPR) and the idea of maximum practical losses, you can approximate what your likely worst-case scenario will look like.
Maximum practical loss
First, we must differentiate between maximum theoretical loss and maximum practical loss. With naked options, specifically on the call side, the maximum theoretical loss is infinitely large.
There is no ceiling to how high a stock could rise, and thus there is no theoretical limit to how much you could use on the wrong side of a naked short call. However, for this to occur, the stock would have to literally rise to infinity—something that clearly has never happened and will never happen. As a result, we need a way to measure a more realistic worst-case scenario, and this is where the BPR on the position comes into play.
Buying power reductions
Essentially, the BPR is the amount of capital the brokerage firm is forcing you to set aside to hold this naked position.
The actual amount of the BPR is determined by a myriad of factors such as stock price, strike price, and implied volatility, but the overarching goal for all BPRs is to capture the capital needed to cover a two standard deviation move in the stock. Therefore, by looking at the dollar amount of the BPR, you have a good approximation of the practical loss you would have to absorb in the event of a sizable move against you.
Again, to be clear, you can certainly lose more than that on a naked options position, and there will be times during your options career that you will lose more than this. But by and large, on a trade-by-trade basis, the BPR required to hold the trade gives you a reasonable estimate of your maximum practical loss.
Jim Schultz, a quantitative expert and finance Ph.D., has been trading the markets for nearly two decades. He hosts From Theory to Practice, Monday-Friday on tastylive, where he explains theoretical trading concepts and provides a practical application of those concepts to a trading portfolio. @jschultzf3
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Options involve risk and are not suitable for all investors. Please read Characteristics and Risks of Standardized Options before deciding to invest in options.