The case for selling naked short calls

The Surprising Benefits of Naked Short Calls

By:Dr. Jim Schultz

In a portfolio overly exposed to long delta and short volatility, the naked short call can serve specific purposes

  • The market has gone higher over time, so most people automatically assume a naked short call is a poor strategy selection.
  • While short puts have many strategic benefits, they are exposed to the “double whammy” of a market drop plus a volatility pop.
  • Where a short call that is getting from direction actually benefits from the likely volatility decrease that is accompanying the market rally.

Over time, the market goes higher—at least that’s what happened in the last 475 years of market history. So strategically, a strategy like the short put makes sense. You benefit from the market going higher. You benefit from volatility going lower. And you benefit from the simple passage of time. That makes for wins across the board.

But the effectiveness of the short put doesn’t automatically mean its mirror image, the short call, should be shunned. In doing so, you might be giving up a unique way to diversify your portfolio strategically.

Double whammy

Even with the greatness of the short put, there are some downsides to the strategy. Sure, when everything works and the market rallies, you’re firing on all cylinders with the short put, and you get paid off pretty quickly. But what happens when everything doesn’t work? This is where the chink in the armor that is the short put strategy is front and center.

When the market drops with a short put, not only do you get hit on the delta effect from being wrong directionally, but you also most likely get hit on the vega effect, too. Short options are always short volatility. Therefore, if volatility rises, short options suffer. During a market drop, volatility is almost always on the rise. As a result, your short put gets hit from both angles: the market decrease and the volatility increase.

But this same relationship does not exist with short calls. 

The short call finds a home

If you are wrong directionally and the market rises against your short call, you are naturally going to get hit. But the same inverse relationship between market prices and market volatility that hurt you even more on your short put in a falling market actually softens the blow on your short call in a rising market. As the market rallies, volatility is most likely decreasing, and thus your short call benefits from that falling volatility. But, this gimme is not without its own gotcha.

Now, don’t get me wrong. I’m not suggesting you pivot from the tried and true short premium strategies, like short puts and short strangles, and go wild selling calls across the board. But I also don’t think the naked short call deserves the automatic dead-on-arrival label it’s typically given. In a portfolio that might be overly exposed to long delta and short volatility, the naked short call can certainly serve specific, strategic purposes.

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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