Don't Get Caught Naked

Once people learn about the incredible profit potential of options, they suddenly want to learn as much about them as quickly as possible. Of course, there’s nothing wrong with that — I encourage my readers to explore all the possibilities options contracts offer.  The trouble comes when budding traders hear about a new strategy and jump in without getting all the details.

Perhaps the biggest trap is the concept of writing options. I’ve seen some analysts touting it as an easy way to enjoy some quick income. But there’s a lot more to this process than you usually hear. (By the way, things are going to get a bit technical — but that’s partly the point. The only way to fully appreciate the dangers is to fully understand what writing options is all about.)

As you probably know, stock options are tradeable contracts giving you control over 100 shares of stock. If you buy a call option, you earn the right to buy the stock at a set price — so you want the stock price to go up. If you buy a put option, you gain the right to sell the stock at a set price — so you want the price of the stock to go down.

But that’s really only half the story. After all, option contacts just don’t appear out of thin air. There have to be sellers as well as buyers. The process of selling options is called "writing" — and the person who does it is called the "writer."

As you might expect, option writers have different goals than buyers. Someone who writes a call wants the stock price to fall, or at the very least stay the same. A put writer wants the stock price to rise or stay the same.

The thing that makes writing options so unique is that you get money for the position right away. That’s because, technically, when you write an option, you are effectively writing a brand-new contract, one that hasn’t existed before. Your broker then immediately sells the contract to the market, and you instantly receive money for the contract.

The instant gratification angle is why writing options appeals to so many traders. Throw in the fact that 90% of options expire worthless, and you might think you’re looking at a perpetual profit machine. But the 10% of options that don’t expire could be the source of a major headache down the road.

Remember, options are contracts — and as a writer of the contract, you’ve taken on certain obligations. Lose sight of those obligations, and you could quickly find yourself in over your head.

Say you write a put option for a made-up company we’ll call ComTec. And let’s say ComTec is currently selling for $113 on the market, so you sell the contract with a strike price of $110 and an expiration date six months out. And, in this example, the going market rate for an October 2007 $110 ComTec call is $500.

So, you call your broker and have him sell the contract on the open market for $500. That money is put into your account right away…and it’s yours to keep. Doesn’t sound like a bad deal…but things aren’t over yet.

For the next six months, you’re at the mercy of ComTec’s stock price. If ComTec’s stock price goes up, you have nothing to worry about. It can even stay at $113 without a problem. But if the stock price starts to plummet, look out.

The second the stock hits $110, the person holding the contract has the option of exercising it. In other words, you will be obligated to buy the 100 shares of ComTec shares he has the right to sell. That’s $11,000 you have to shell out to honor your end of the contract…giving you 100 shares of stock that’s losing value.

Now, keep in mind, though, that this is all theoretical. In reality, you sold your option to "the market" — who randomly sold it to a buyer. There isn’t a specific person holding the contract you wrote. So when a put holder decides to exercise, the market randomly assigns a put writer to fulfill it.

In other words, there isn’t a specific person you have to worry about exercising the specific option you sold…you’re worrying about anyone who bought similar contracts.

So as ComTec falls lower and lower, it becomes a game of Russian roulette — you never know if the market is going to choose you to fulfill the contract. But if it does, you’ll have to pay $110 for 100 shares of ComTec — no matter what the going market price is. Even if the share price falls to $80, you’re still shelling out $11,000.

If you sell them at $80, the $500 you pocketed selling the option has turned into a $3,000 loss. (You spend $11,000 to buy 100 shares, then get $8,000 selling them on the open market.)

Now, there are circumstances where writing put options may be a good strategy. But for most people, it’s strictly a gamble — and not a very good one at that.

The same goes for selling calls. As you should know, one of the wonderful things about options is that you can trade them even if you don’t own the shares of the stock they cover. In other words, even though you don’t own 100 shares of a stock, you can still buy a put on it — giving you the right to sell shares of the company — and trade it like any other instrument.

That is not necessarily the case when you write a call option. In this case, it helps to own the shares of the stock. It’s called a "covered call."

Let’s say you own 1,000 shares of ComTec, and the stock is selling for $113. Now let’s say you write an October $120 call for ComTec, and it sells on the market for $500. You pocket the $500 immediately…but an option buyer can force you to sell him 100 shares of ComTec for $120 — no matter what the market price is.

So if ComTec goes to $150, you might have to accept $120 a share for a stock you could have sold for $150. Notice that the only penalty here is one of opportunity. You still collect $12,000 from the person buying your stock…and you still have the $500 from selling the option in the first place. Of course, if you hadn’t sold the option in the first place, you could have made $15,000 selling the stock on the open market instead.

What happens if you don’t own shares of the company? Well, you can still sell a call. It’s called a naked call.

You never want to sell naked calls. That’s because if the person decides to exercise the option, you’ll have to buy shares from the open market…and then immediately sell them to the contract holder.

So, let’s use the example above, only say you don’t own any ComTec shares. The contract buyer exercises the $120 option when the stock is at $150. To fulfill, you need to buy 100 shares of ComTec for $150 — $15,000. Then you sell them to the buyer for $120 each — or $12,000. Figure in the $500 you got selling the option in the first place — and you’re looking at a net loss of $2,500.

Ouch!

If it sounds complicated, don’t worry — it is. The takeaway lesson is that writing options isn’t a smart strategy, especially for novice investors. There are too many things to worry about, too many things that could go wrong and it’s too easy to lose a lot of money.

That’s why I recommend keeping things simple. The fact is, you can reach most of your goals with simple puts and calls. Buy them cheap, and if they increase in value, sell them. If not, get out. Either way, you’re in complete control of your financial future.

Sincerely,
Steve Sarnoff

May 2, 2007