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What types of options positions create unlimited liability?

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posted Jul 14 by Chetan Hindu

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Selling naked calls creates unlimited liability. Therefore, these types of option strategies are considered appropriate for sophisticated traders with proper risk management and discipline due to the limitless losses.

Selling calls is typically done against existing stock holdings in an attempt to create income from the position by capturing premium. For example, assume that a trader owns 1,000 shares of Apple Inc., which is trading at $125. The trader sells 10 calls at a strike price of $150 for $2. Each option contract represents 100 shares, so the sale nets the trader $2,000.

Essentially, if Apple climbs above $150, the trader must sell his position or buy back the options. If Apple does not climb above that level by the option's expiration date, he can hold onto his shares and pocket the premium. Owning the shares takes the risk away from this strategy.

In the case of naked selling of call options, the risk is theoretically unlimited. Suppose a trader sells calls on a company that is trading for $10. He believes the upside is limited for the company and sells 100 calls at a strike price of $15 for $1. From this sale, he collects $10,000.

It turns out that the trader's judgement is incorrect, and a competitor buys out the stock for $50. All of a sudden, the call options that the trader is short climbs to $35, even though he sold them for $1. His $10,000 profit would turn into a $350,000 loss. This example illustrates the dangers of naked selling call options.

Naked selling of put options can be quite dangerous in the event of a steep fall in the price of a stock. The option seller is forced to buy the stock at a certain price. However, the lowest the stock can drop to is zero, so there is a floor to the losses. In the case of call options, there is no limit to how high a stock can climb, meaning that potential losses are limitless.

answer Jul 15 by Sherlyn Mishra
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