Lessons from the Pros

Back to the Basics: Part 3

In my last article, Back to the Basics: Part 2, I presented four different levels of option approvals, and in the very last sentence of it, I hinted about my next topic – the risk associated with the option market. Here, in this article, I will scrutinize the risk associated with trading different option strategies against the four levels of brokers’ approval. My intention is to demystify the myth of the true reason behind the different levels of brokers’ approval. Are they truly in place to protect us, the traders, from the risk in the option market, or are they in place to protect the brokers? Let’s embark on the journey of finding it out.

One of the easiest ways to present the information that I will be discussing is with the use of a figure. Visual aids often present the points more clearly than just mere words. Hence, I have created a chart with several columns. In the first column, I have included the abbreviation. I usually mark a long position with a plus in parentheses, while for a short position I use a minus sign. Calls are marked by c and puts by p. In the case of a long stock, I used LS for it. The second column names the strategy, while the third one assigns to it the option level of approval by the broker, which I discussed in the previous week’s article. The fourth and fifth columns are the most essential ones for they are dealing with the risk perspective: broker’s versus ours. The last, sixth one, presents the trader’s reward.

Going through Figure 1 from top to bottom, the covered call is most often misunderstood for being the most conservative option strategy out there. This is true from the broker’s view point, for the investor owns the stock on which he or she is selling the calls and consequently, receives the premium for it. If the call expires worthless, then the investor keeps both the stock as well as the premium. However, if the stock plummets, the limited premium that the investor has received is very small protection from the southbound move. The investor’s loss could be substantial while the broker’s loss and risk is non-existent.

The second strategy involves outright purchase of calls or puts. The most an option trader could lose is only the amount the trader has invested in buying of the premium. In the case of a long call, the stock could go down to zero or even get de-listed, yet the trader can lose only what was invested – not a penny more. Meanwhile, the broker has received his commission and has absolutely no risk.

The third is my favorite strategy – Spread Trading. I tend to call it "being a net premium seller". Let me define it. Being a net premium seller, in my eyes, means being a seller of premium regardless of whether the final outcome is a credit or debit spread. As long as I am being protected and unexposed, I am considering myself a net premium seller. The key thing is to be covered or protected by another option rather than by the stock. I have been beating the drum more for Spread Trading than for any other strategy because, in my humble opinion, it is the least risky option strategy.

Nevertheless, being a net premium seller is just one of the MANY different ways of trading options. In option trading there is never one right way of trading them. For me personally, being a net premium seller is my preferred way. (It takes a mature trader to recognize that he or she could be a friend with an option trader who trades completely differently than he or she does.)

For those who need a refresher on when it is financially better to do one type of spread over another, you could read my article on Debit Spreads versus Credit Spreads. The main reason why I like spread trading is that I have clearly defined risk and reward. No other option strategy gives me such comfort as this one. Meanwhile, the broker has no risk.

The fourth strategy is selling of uncovered puts and the fifth one is selling of naked calls. As it can be observed from Figure 1, it is only at these last two that the broker gets true exposure to the option market risk.

Please observe that I have purposely used two different terms "uncapped" and "unlimited" in Figure 1 which linguistically mean the same thing in order to point out a slight but essential difference. Before I lay out where the difference is, let me point out why naked put selling is less risky than naked call selling. When a trader sells a put, the trader actually wants the sold put to expire worthless, which means the stock (underlying) should go up. Nonetheless, what happens if the trade goes in the opposite direction? How low can the stock go down? To zero. Zero is the cement floor; the stock cannot possibly go into the negative territory below zero.

Hence, I used the word "unlimited" in italics when indeed it means only "theoretically" unlimited, for it is zero that creates the limitation.

Now let us flip a coin and talk about the naked call. Had a trader sold a naked call and it had gone sour, how far can it go up? Is there a "cement" ceiling? No. The stock can take off to the moon and that is why naked call selling is considered the highest option risk taking strategy. It is only in selling of the naked calls that the risk to the option trader as well as to the broker is uncapped. (By the way, naked call selling on the indices is the worst of the worst. It is off the chart. It is not on Figure 1 and not a part of this discussion.)

As a final note, observe that in the case of covered calls and naked puts, I have used the terms in italics. Why? Because any well-informed option trader knows that the risk profile graph for covered calls and naked puts are identical. Both strategies have unlimited risk yet at the same time, limited reward. Hence, it is from the broker’s point of view that covered calls hold the lowest ranking in terms of risk which explains why the selling of covered calls requires only the lowest level of option trading approval. (As a side note, not every brokerage company has the same requirements; some more specialized in option trading are more progressive and they do recognize that by the risk profile graph, there is absolutely no difference between the selling of a naked put and covered call.)

From the brokers’ perspective, it is with naked puts that they have a greater chance of loss, for if the trader cannot fulfill his or her obligation of selling puts then they are on the hook. The way brokers protect themselves is by not giving this level of approval to everyone.

In conclusion, I have presented to you the facts. Draw your own conclusion based on what you have read. Are the different levels of option approval in place to protect us, the traders, or are they in place to protect the brokers, or possibly both parties? As Alexander Elder said, in his best-selling classic, "Trading for a Living," – the brokers laugh all the way to the bank.
– Josip Causic