Naked Option Selling: Beware of the unexpected

Published on: Feb 21 2013 by John Critchley

An old myth in the options world goes: 90% of options expire worthless so always sell, never buy.  This is False, False.  A Myth, Myth.

 

If you aren’t careful, naked option selling may leave you just that: naked or without any funds.

Case In Point:  On Wednesday February 13th, 2013, unknown call buyers bought 2,533 HNZ Jun ’22 65 calls for an average price of approximately $.35 Total outlay $88,000.  On Thursday, February 21, 2013 it was announced that Berkshire Hathaway and 3G Capital were going to buy Heinz for $28 billion, or $72.50 a share.

These call options bought for $.30 soared to $7.00.  The $88,000 price paid for these options had grown to $1.7 million. 1,700% gain. Not bad for a day’s work.

 

Not surprisingly, Securities regulators filed suit against unknown traders in the options of ketchup maker H.J. Heinz Co, alleging they traded on inside information before the company announced a deal to be acquired for $23 billion by Warren Buffett’s Berkshire Hathaway Inc and Brazil’s 3G Capital.

 

 

According to the Chicago Board Options Exchange:

-            about 30% of options expire worthless in each monthly cycle.

-          about 10% of options are exercised during each monthly cycle,

-          In fact, over 60% of all options are traded out in the marketplace. This means that buyers sell their options in the market, and writers buy their positions back to close.

 

So we see that the “90% of options expire worthless idea” is… a myth.

 

The fact it that there is no inherent edge in buying or selling options at point of inception, if they are correctly priced. Simply stated, there is no way of knowing whether the option premium is cheap or expensive, because we don’t know what the underlying is going to do.

 

The debate over what percentage of options expires out of the money misses the point. Even if it were true that 90% of options expired worthless it would mean nothing. There’s also the matter of how much you make on your winners vs. how much you lose on your losers.

If one makes money 9 times out of 10 – but that 10th time loses 20 times what he made the other 9 times – he’d still be a loser.

I bet the sellers of those options in Heinz (HNZ) wish they had taken my advice before they were fleeced for $1.7 million.

 

Stay tuned…..

 

 

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2 Comments to “Naked Option Selling: Beware of the unexpected”

  1. Michael says:

    Would you agree that while they may have lost big one time if done naked selling that they also may employ delta neutral trading, so for every option sold they have a varying amount of stock or short puts/spreads that would have made loss only marginal?

  2. Miguel Angel says:

    Besides, the probability of touching the strike we have sold is bigger than the probability of expiring in the money. And when the option is not out of the money we would probably adjust in one way or another case we hadn’t adjusted before.

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