The Risk of Going Naked (Part 2)

I recently presented some excerpts from an online forum regarding the risk of trading naked options.

This is the kind of sobering talk that makes me uncomfortable with leverage. Regardless of the extent to which market turmoil occurred in the backtesting period, a severe enough market crash could always bring to fruition something worse.

Without leverage, drawdowns tend to be minimal, risk of Ruin is relatively small, and quality of sleep is restful throughout. While I am tempted to take advantage by boosting position size for better total return while maintaining equal or lesser drawdowns, doing so means adding leverage right back into the equation.

If I want to hedge myself against the most extreme moves then I can buy [cheap] insurance. This will increase return on capital. This will also save me if the catastrophic market crash actually takes place, which has anecdotally happened every 5-7 years throughout the current century. The market will more commonly fall several percentage points and level off or reverse higher. This magnitude of correction is nowhere near that required to realize max loss on the hedged naked puts (vertical spreads). The breakeven point would require an even larger drop since the insurance is not free.

And while that max loss is much lower than the “undefined risk” of naked puts, the loss is probably catastrophic either way. I’m tempted to backtest this and look at different position sizing but the sample size would be too small to allow for any meaningful conclusions.

I think it would be nice to insure the extremes and be able to claim “were the market ever to crash to zero, you would be covered [or even profit].” A total market crash is what doomsday forecasters love to prognosticate. Hedging against this is always possible with options but it comes at the cost of lower profitability during normal market action. My preferred solution is to allocate no more than X% of one’s total portfolio to this sort of “unlimited risk” trading.

Allowing for the possibility of catastrophic loss and managing risk by position sizing is, in my mind, what has relegated a strategy like this to accredited investors and hedge funds.

Then again, this argument could be easily contested. Common stocks—purchasable with leverage to investors who are not accredited—also go to zero (e.g. bankruptcy). While baskets of stocks rarely go to zero and indices have never gone to zero, all of the above have suffered catastrophic losses: pick any stock market crash. Limiting total portfolio allocation, therefore, is probably smart whether dealing with naked puts or long stock.

In the eyes of the regulators, naked puts would probably be okay for anyone as long as position sizing is based on Reg T margin requirements (i.e. cash-secured).