How I Trade Uncovered Options

From my experience, the secret to winning at the naked option writing game is to find very high probability plays. I write naked options for speculation that have a very high probability of paying off.

Whenever you write naked options, you must use a stop loss to survive.

I use a stop loss based on the underlying stock, index or futures, but, even better, using a simulator you can determine the probability of hitting the stop loss during the life of the option.

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I am always in search of a sure thing. Whenever the probability of success is greater than 90%, I have a potential play. The key to finding high probability plays is to write far-out-of-the money options.

My best play was a Cell Pathways (formerly CLPA) 7.50 put priced at $1 ($100 per contract) with about two and a half months before expiration, but the underlying stock was priced at $48, a country mile from the strike price. There was no reason to run the simulator, for the probability of hitting 7.50 would have been 0.

However, a word of caution here: When an option is extremely overpriced or extremely under priced, there is probably a reason. In fact, ironically, buying and selling stocks based on this premise can be a profitable venture.

Here there was a reason: Cell Pathways, a drug company, had a drug that was coming up for FDA review. However, after a review of the price chart for CLPA, I found a lot of support at $10, and I probably would abort or get out with a small loss if it hit $10.

The worst-case scenario would be that I would get the stock for a price of $6.50. (The put buyer had the right to put the stock to the writer at $7.50, but I already had $1 credit in my pocket, so my cost was $6.50.)

Even if CLPA were to go bankrupt without letting me out of the position, an unlikely scenario, my maximum loss would be $6.50. Here, I thought I had found a slam dunk play.

The extremely overpriced puts were a good signal that the stock would decline, and it did, down to $15 from $48, but that still was far from the strike price of the puts that I had written. I had an easy win as I predicted.

You see, the option writers who write out-of-the-money options have two factors going for them: time and distance.

To get writers in trouble, the underlying price must move against them fast enough to beat the expiration date and far enough to hit their stop loss or strike price, sometimes an almost impossible task.

Ken Trester started trading options when the first exchanges opened in 1973. He has been a computer science professor at Golden West College in Huntington Beach, CA, where he also taught a course on stock options trading. Ken is also widely quoted in publications such as Technical Analysis of Stocks & Commodities and Barron’s.

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