Naked Options Trading Explained: Risks and Strategies for the Informed Trader

In recent years, retail traders in India have developed a newfound interest in the derivatives segment — particularly, in options trading. The country’s F&O segment recorded 85 billion options trades in 2023 — which surpasses the options trading volume in other derivatives markets across the world. More recent data revealed that retail traders account for 35% of these options trades.

While this may seem to be a positive development on a standalone basis, it hides a startling truth beneath the rising participatory numbers among retail traders. 9 out of 10 individual traders in this segment suffer losses, as a recent SEBI study discovered. This has left regulators alarmed because instead of relying on tried and tested trading techniques that balance risks and rewards, most traders are simply engaging in speculative trades — without creating any options trading hedge to cut the risk of losses.

To help traders identify more suitable trading strategies and set up adequate options trading hedges, we at Samco Securities have developed a pioneering strategy builder — Options BRO — that analyses risks and rewards within seconds and pinpoints winning techniques for maximum success.

A Closer Look at Naked Options Trading and What it Entails

Naked options trading involves buying or selling option contracts without owning the underlying asset or having a corresponding position in another options contract. This strategy is considered ‘naked’ or unprotected because you do not have the safety of holding the underlying stock or an options trading hedge that may limit potential losses.

There are two primary types of naked options trades: naked calls and naked puts.

  • Naked Call

In a naked call, you sell the call options of a given security without owning the underlying shares. For example, if you expect a stock’s price not to rise above a certain level by a specific date, you may sell a call option at that price.

If the stock remains below this strike price, the option will expire without any worth and you get to retain the premium paid by the buyer. However, if the stock exceeds the strike price, you will be obligated to provide the shares to the option buyer at the strike price, thus incurring significant losses depending on how high the stock’s price rises.

  • Naked Put

Conversely, a naked put involves selling put options without having a short position in the underlying stock. Here, you anticipate that the stock’s price will not fall below a certain level. If the stock stays above the strike price, the option expires worthless and you retain the premium. But if the stock falls below the strike price, you must buy the shares at the strike price, which could result in a loss if the market price is significantly lower.

Dissecting the Risks in Naked Options Trading

To better understand why the all-new strategy builder in the Samco trading app is a game changer, you need to be aware of the risks in naked options trading. Let’s take you through the main challenges you may face when you do not utilise any options trading hedge.

  • Unlimited Potential for Losses

One of the most daunting risks of selling naked calls is the potential for unlimited losses. When you sell a naked call, you are obligated to sell the underlying asset at the strike price if the option is exercised. If the price of the underlying asset shoots up, your losses can grow infinitely since there is no cap on how high a stock price can climb.

  • Substantial Losses from Price Drops

Selling naked puts can also lead to substantial losses. Although the loss is technically limited to the difference between the strike price and the premium (since a stock’s price cannot go below zero), this can still represent a significant financial hit. If the market price of the underlying asset falls significantly below the strike price, your losses can be huge.

  • Margin Calls and Leverage

Naked options trading requires significant margin requirements because of the high risk involved. If the market moves against your position, you may face margin calls and require additional funds to be deposited to maintain the position. This can lead to a liquidity crunch and force you to liquidate positions at unfavourable prices.

  • Timing and Directional Risk

Buying or selling without any options trading hedge requires accurate predictions about the direction and timing of the underlying asset’s price movements. Misjudgments can rapidly erode your capital, especially as the option approaches expiry. You also need to account for these risks before trading in naked options.

Multi-Legged Hedged Strategies: A Safer Alternative to Naked Options Trading

Multi-legged strategies offer an inherent options trading hedge, making them a safer alternative to naked options trading. They combine multiple options positions to create strategies that can reduce risk while still offering some profit potential. Here are some common multi-legged strategies with an options trading hedge built in.

  • Covered Calls

To execute a covered call, you must own the underlying asset and sell a call option on that asset. This strategy gives you income via the premium received for the call option. The underlying asset serves as the options trading hedge against the call. This strategy is ideal if you’re looking to generate income on their holdings with a view that the stock will not significantly increase in price.

  • Protective Puts

In a protective put, you buy a put option for an asset that you already own. This strategy acts as a hedge against a decline in the stock’s price. The put option increases in value as the stock price falls, thus offsetting the loss. So, it’s particularly useful if you want to protect any unrealized gains or set up an options trading hedge against potential losses without selling your stock holdings.

  • Iron Condors

An iron condor is a technique that requires you to sell an out-of-the-money (OTM) put and call and buy a further OTM put and call, all on the same asset with the same expiration date. This strategy creates a profit range between the two strike prices of the options sold. It’s best used in a market with low volatility, as you can profit if the asset’s price stays within the specific range.

  • Butterfly Spreads

In a butterfly spread, you buy and sell options at three different strike prices. It is a four-legged strategy that involves buying one in-the-money (ITM) option, writing two at-the-money (ATM) options, and buying one out-of-the-money (OTM) option. It’s a low-cost, low-risk strategy that’s ideal for predicting stable prices, and it helps you profit if the underlying asset remains near the middle strike price at expiry.

Look Beyond Naked Options Trading with Samco Securities

Multi-legged hedged strategies offer better risk management by limiting potential losses, but they involve more complex setups than single-option trades. To identify the best strategies to create an options trading hedge in any given market condition, you need to analyse thousands of techniques and lakhs of data points. Manually, this is impossible due to the sheer volume of data and the highly dynamic nature of derivatives trading.

Here’s where our options strategy builder — Options BRO — can be your new best friend. All you need to do is submit key details like the scrip you want to trade in, its expiry and your market outlook in the Samco trading app. The Samco strategy builder then performs superhuman analysis within seconds to deliver the top 3 winning strategies for conservative, modern and aggressive investors.

The Key Benefits of Options BRO from Sacmo Securities

The options strategy builder in the Samco trading platform offers wide-ranging benefits that include, but are not limited to the following:

  • Top 3 Strategy Recommendations from 1000+ Possibilities

Options BRO meticulously analyses over a thousand potential trading strategies to present you with the top three, so you’re equipped with the most effective options based on current market outlook. This selection process maximises your chances of success by narrowing down the vast array of possibilities to the strategies best-suited for your trading goals.

  • Comprehensive Market Data and Analysis Tools

Options BRO conducts a comprehensive analysis that incorporates option Greeks, Implied Volatility (IV), expected value and risk-reward ratios among other critical data points. This deep dive into the intricacies of market dynamics and option behaviours provides a solid foundation for making informed trading decisions.

  • Rapid Analysis for Timely Strategy Selection

Leveraging cutting-edge technology, Options BRO performs complex analyses of multiple data points and strategies in mere seconds. This swift processing capability means you receive timely and data-driven strategy recommendations that allow you to capitalise on market opportunities with confidence.

  • Customised Strategies to Match Your Risk Profile

Catering to the diverse risk tolerance levels of traders, Options BRO offers strategies ranging from conservative to aggressive. This ensures that whether you’re risk-averse or seeking high-reward opportunities, there’s a tailored strategy to match your risk appetite and align with your financial goals and comfort level.

  • Wide Range of Strategies with Over 1000 Combinations

With access to over a thousand strategy combinations, Options BRO empowers you to explore a vast array of trading possibilities. This extensive range encourages experimentation and discovery, and makes it possible for you to refine your approach and identify the strategies that resonate most with your trading style and objectives.

  • One-Click Execution for Strategy Contracts

Options BRO also simplifies the process of executing strategies and enables you to implement all contracts within a chosen strategy with just a single click. This streamlined approach saves time and also ensures that you can enter strategic positions in the market efficiently, without missing out on any opportunities.

Switch to the Samco trading platform today, complete the Samco account opening process today and enjoy access to a wealth of analytics, insights and tools — all in one place and all available free of cost.

News Reporter