The Trading Risk From Selling Short Uncovered Options

Since short option selling strategies that include uncovered options are part of our trading method strategies, it is very important to discuss and understand the potential risk to these trades.

And then, if it still fits the trader’s risk profile to have trading positions with uncovered options, it is equally important to understand how to decrease the inherent risk, which is a large component of our options trading strategies.

Why is there a problem with selling uncovered options?

The profit is limited to what the option was sold for, while the potential loss is unknown and without a limit.  This is in complete contrast to buying options, where there is no limit to the gains, but the maximum loss is the cost of the option.

So, with this risk reward, why not just buy options instead of selling them?

It’s just human nature that people love the idea of getting something for nothing, especially when they hear that in excess of 70% of all options expire worthless.

Short Uncovered Call Trade RiskConsider that a stock is at 47 and you sell a 50 strike call for .50.  Not only were you just given that $50.00 like found money – that amount is completely time value.

This means that if the stock is 50 or less at expiration, then the option will expire worthless and you get to keep all of the money.

This idea of selling worthless options has a tremendous draw on many people.

Oh, the horror stories that I have heard.  I’ll save you all the details, but it basically goes like this – short strangles are sold multiple strikes out of the money to increase the likelihood of expiring worthless.

But to get a decent credit they actually need to do things that add greater risk to their trades:

  • Selling options with higher implied volatility
  • Selling options with lower volatility in ‘quiet’ periods
  • Selling options with more time to expiration
  • Doing bigger size trades

And they do this with multiple different stocks, which instead of increasing safety with diversity, it increases the likelihood that one of the stocks will make an outlier move.

So, the stocks tend to be the higher momentum stocks.  The stocks with frequent news and stories that cause big price moves, or have an earnings report well outside of what was priced into the options – and sometimes the strangle is inadvertently sold on a company that is bought out.

And all of a sudden those ‘safe’ out of the money short strangles explode in their faces, when some significant news event comes out – which is magnified by the extra trading size.

Short Options Strangle Trading Scenario

Let’s consider a scenario where a cheap out of the money options strangle was sold – in this case the implied volatility was actually on the lower end, while the stock was consolidating.

Short Options Trading Risk Reward

  • The underlying is 47.00 with implied volatility in the low 40’s
  • The date is 11/21 and the options are sold for the 12/21 expiration
  • Sell 1 55c .23 and 1 40p .20
  • That gives a .43 short strangle that is around 15% out of the money

On 11/30 there are rumors of a significant product getting ready to be announced that will add 12 to 15 percent to earnings – and here is what happens:

  • The news comes out and the stock moves around 20% to 57
  • Options implied volatility goes up to 70% – maybe there is more to announce
  • The .43 short strangle is now a -4.45 loss
  • And you did 20 of them to get an $860 total sell = $8900 loss

Oh yeah, I guess we shouldn’t forget that this was done on 5 different stocks, so that loss is reduced by those gains – or was it, with these kinds of high momentum news stocks, why couldn’t this had happened to another one of the short strangles too?

Should You Stop Selling Short Uncovered Options

Did I scare the crap out of you and convince you that you should stop selling uncovered options – stop thinking that you can keep raking in the premium from those cheap out of the money short strangles, without doing anything?

So, what is the attraction to taking that kind of risk?

To begin with, they aren’t viewed as risky trades, not with their strike locations.  And then there is that attraction for being able to make all this money with doing nothing – that means that you can be working another job and still sell those short strangles.

Good Luck!

My intentions were to give you a strong appreciation and understanding for the huge potential risk involved – if it was really so easy, then everyone would be doing it and getting rich.

And the thing about statistics and saying how high the percentage is that those trades will expire worthless, certainly doesn’t mean that your next five trades won’t blow up on you and wipe out your account.

In our example, a .43 short strangle was sold, with 30 days to expiration.  There was no type of trade setup or entry timing, based on the proximity to resistance or support – the trade was done based on ‘centering’ the current stock price between two out of the money strikes.

One of my recent trades that included selling an uncovered call was a Facebook 52.5 call, with 13 days to expiration.  I sold the option for 1.40, when the stock was around 51.45 – the short option entry timing was based on a chart read including:

  • A resistance double top
  • Momentum extreme indicator cross
  • Chart reverse into sell

Off of this entry setup, facebook went down to 49.75 and the decision to hold the short call uncovered was made – knowing that it would take an 8% gap open, from some kind of unscheduled news, to take the stock to the breakeven point of the short call.

I would also be available to further manage the trade the next trading day.

The option did expire worthless and 1.40 was made on the managed short call –vs- a .43 potential on the do nothing [but hope] short strangle.

So no, my intentions were not to convince anyone that short options strategies that include uncovered options, can’t be done in a way that manages the risk – but the related trading strategies will never include selling cheap short uncovered options strangles that you do nothing with and just wait for them to expire worthless.

But before I can discuss our trading method short options trading strategies – I have to be positive that I have emphasized the risks involved with uncovered short options trades.  And then, I can talk about our trading strategies, along with the risk management components.

We might lose on a short option, but it would be highly unlikely to be in an uncovered trade that blows up on use – there would be a greater likelihood that the short was covered by a stock trade, or the breakeven range had been expanded by doing a ratio option short.

It would take a significant and unknown company news release [we would always avoid holding uncovered options for earnings] that came after market hours, because during market hours we would be managing our short option trading risk.