The Risk of Going Naked (Part 1)

Today I want to step back and review the risk of trading naked options.

The following exchange occurred in a Yahoo! Group I followed back in May 2015. R started it out:

     > I think anyone selling options should read
     > The Black Swan by Nassim Taleb to understand
     > low probability, high impact events. This is
     > the risk with leveraged naked option selling.
     > To give an extreme example, nobody in their
     > right mind plays Russian Roulette with a gun that
     > has a barrel with 99 empty chambers and just
     > one bullet. Even though you are “correct” 99% of
     > the time, when you are wrong it’s game over.

V wrote:

     > I was in no way doubting your numbers. I just
     > wanted to know if you were writing closer or
     > using more margin or different underlyings.
     > I apologize for the misunderstanding.

V also wrote:

     > It’s all good. I appreciate the openness of
     > the group and the desire to educate and
     > enlighten everyone. The returns are beating
     > all hedge funds, which is amazing to me. I
     > hope I didn’t come off as skeptical.

I responded:

     > You should be skeptical, V. Recent posts by R
     > about naked option selling raise an extremely
     > good point and very scary possibility for those
     > trying to make a living by doing this. The other
     > side of the coin is that this work should not
     > simply be dismissed because it’s naked option
     > selling. There’s plenty of reason to think that
     > it can work given particular management
     > techniques and strategies: much of which are
     > discussed in this group.
     >
     > Another reason to be skeptical is that even
     > people who report solid returns are sometimes
     > “under the influence.” They may never have
     > seen significant downside and may be ignorant
     > as to how positions are affected when volatility
     > truly explodes. People might report returns
     > accurately but, as R noted, if those returns are
     > annualized and we have a 2 SD downmove a
     > couple months later then those annualized
     > returns will never be realized.
     >
     > Whenever people start talking or writing as if
     > anything in trading is a sure thing or an ATM
     > machine, I become suspicious. I believe that’s
     > when you should start asking what they’re
     > missing or where they are wrong. If you
     > can’t find anything then maybe they are truly
     > onto something.

I will continue next time.