Unlimited Risk, My Foot—An Amazing Myth

One of the most pernicious myths ever propagated by ersatz experts, and,oddly, by not a few thoroughly real experts too, has to do with one specific tactic that we might employ in using options in our trading. This is the myth of “unlimited risk” when a trader writes an option without also having an offsetting position in the underlying asset. This tactic is usually called writing a “naked” option, and this myth is incredibly pervasive.

Some of the world’s finest writers on the subject of options, Larry McMillan and Sheldon Natenberg among them, use the phrases “unlimited risk” or “unlimited loss” when discussing naked option writing in their books. This viewpoint just boggles the mind. Let’s take a very stern and objective look at this myth, with the clear intention of putting a case of dynamite and a fast fuse right smack underneath it.

Pick a market, any market, stocks or futures or, for all it matters,nineteenth-century bowling balls (although we should suspect that the liquidity in this last market is a trifle too low for us to trade successfully, and option trading in this market is likely extremely thin). Take two positions in this market that will profit if this market moves up (or down, we can just as easily construct an example for the other direction).

Let’s say that today is July 7, and we buy December Chicago wheat at tonight’s price of $3.333⁄4 per bushel for one position, and write a December wheat 330-strike put for 173⁄4 cents for the other one, temporarily pocketing the option premium. If the price of December wheat goes up between now and November 22 when the option expires, we will profit on both positions. If the price in November is within a few cents either side of tonight’s price, we’ll profit by writing the option and will make or lose a few cents on the purchase of the futures contract.

Obviously, our trading risk shows up when the wheat market goes down.Fine. Suppose July wheat goes to $2.00 between now and November 22.If we take no action in either position, we’ll lose 1333⁄4 cents on the future,plus contest risk. Now, the put option will be in the money (ITM), by 130 cents and will be priced almost exactly at that number, call it 1301⁄2, showing a loss of 1123⁄4 cents (1301⁄2 – 173⁄4), plus contest risk.

My, my . . . how odd.The dollar loss in the option position is less than that in the futures position.Looks like the option trade, in terms of pure dollar loss, is slightly less risky.“Wait just a dang minute,” I hear you shouting. “I’m not gonna stay long December wheat all the way down to $2.00! You think I’m nuts? I’ll have a stop-loss order in there right away, and if it goes down 20 cents or whatever amount you choose to risk],

I’m out.” Sure you will, you’re not crazy. I will, too. So will Tom Clancy, Derek Jeter, the President, and General George S. Patton, Jr. . . . and he’s been dead for 58 years.And—guess what—so too will the trader who wrote the put option. The assorted commentaries concerning the so-called unlimited risk involved in writing naked options all appear to assume that a trader, just because he uses this tactic, has an extra strand of the stupids embedded in his DNA. Does an option writer spontaneously fall into a coma or something when a position goes against him?

What nonsense! Just as those who trade in the underlying asset, the option writer will take some appropriate action to limit his loss, unless he happens to be a certifiable idiot. While there is no formal stop-loss order available to option traders, you, I, or anyone will liquidate the option trade (or possibly defend it, as we’ll discuss in Chapter 7) at or near a pre-determined loss point, just as the asset trader would.

When we write a naked option, we accept a known maximum potential profit and an indeterminate loss if the market moves against us, but the horrific prospect of unlimited risk is simply false to fact. The risk in writing naked options is the change in the ratio of potential profit to potential loss,compared to the potential profit/loss ratio when we either trade assets or purchase options, considered over all the prices to which the underlying market might move until the option expires. Sound familiar?

It should.This so-called unlimited risk turns out to be nothing other than our old acquaintance, expectation. If our expectation in writing an option, either naked or covered by an offsetting position, is positive, we’ll consider undertaking the trade. If not, we’ll find something else to do. If our expectation is initially positive, but begins moving toward negative territory during the term of the trade as the market moves hither and thither, we’ll either liquidate the position or take defensive countermeasures, certainly before the expectation of our trade actually becomes negative.