Directional Plays and Naked Options
Jan 2, 2019
With the United States Federal Reserve recently softening its stance on rate hikes, the financial markets were focused even more closely on trade negotiations between the United States and China through the end of 2018 and the start of 2019.
At the recent G20 summit in Argentina (early December), the world’s two largest economies called for a pause in their ongoing trade dispute - setting aside a 90-day negotiating window without the threat of further escalation. But given that President Trump is anything but predictable, one has to wonder how long that “truce” will hold.
While nothing is ever certain in the trading universe, one has to think that any significant agreement that is “officially” (and finally) struck between the US and China would spark a *big* rally in global markets.
Depending on your own unique outlook for the trade war, it's possible you are currently considering bullish or bearish positions for when (or if) an agreement is eventually struck. Alternatively, there may be other market upcoming market opportunities for which you believe a directional play may be appropriate.
If that is the case, we recommend taking a few moments to review a recent installment of Best Practices, which focuses on "directional trading with naked options."
As a reminder, "naked options' is a term that refers to an options position which isn't hedged with underlying stock (or other options) - a “pure play” in either direction. A naked option position may take the form of a long call, a short call, a long put, or a short put - all of which have clearly defined risk parameters.
Let's be clear that naked short options possess extreme risk characteristics - their maximum loss is theoretically unlimited. On the other hand, naked long options are defined risk positions - the most one can lose is the premium outlaid for the position.
On the bullish side, long calls and short puts perform well when the associated underlying stages a rally. Obviously, the degree to which these options perform is dependent on the precise move in the underlying, and the strike of the naked option that is selected.
On the other hand, when a given underlying suffers a correction, it's short calls and long puts that outperform - these are naturally short delta (i.e. short directional positions).
While most of us already know the above to be correct, it’s possible to review detailed data to ascertain the relative performance of each respective naked options position (long call, short call, long put, short put) using historical data in a given underlying. This is the main reason the aforementioned episode of Best Practices is of particular interest.
On the show, the hosts present research conducted by tastytrade using historical data in SPY which helps illustrate the average performance of each respective “naked” position over the last decade. While the data is certainly valuable, one must keep in mind that markets have been rallying quite strongly since the “conclusion” of the global Financial Crisis (2008-2009), at least until recently.
The slide below summarizes the performance of each respective position type in SPY, and are separated into bullish plays (short puts, long calls) and bearish plays (long puts, short calls). Notice how the data indicates that the short premium positions (short put, short call) both outperformed during this period - despite the fact that one is bullish and the other is bearish:
As you can see in the graphics above, each naked options strategy was backtested using two different trade management approaches - holding the position through expiration, and closing the position after achieving 50% of maximum profit potential. Despite that distinction, the short premium strategies (short call and short put) both still outperformed, no matter the trade management technique applied.
While market bias has assuredly been bullish over the majority of that period, another big factor to consider is that short premium positions on average have a higher probability of profit than long premium positions. That means that even in cases where the underlying didn’t necessarily perform as expected from a directional standpoint, the short put and short call still got a contribution to the bottom line from time decay.
If you’re looking at potential directional plays in the upcoming weeks or months, the data presented in this episode of Best Practices may help you optimize your approach. We hope you’ll take the time to review the complete episode of Best Practices when your schedule allows.
In the meantime, if you have any questions on naked options, or any other options trading strategy, don’t hesitate to contact us at @tastytrade on Twitter or by sending an email to firstname.lastname@example.org.
We look forward to hearing from you!
Sage Anderson has an extensive background trading equity derivatives and managing volatility-based portfolios. He has traded hundreds of thousands of contracts across the spectrum of industries in the single-stock universe.
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