Real Risk of Naked Puts (Part 1)

Trading naked puts (NP) involves significant risk that people may not realize.

I have written multiple posts on this topic including a nice mini-series beginning here and a more recent exploration here.

NPs can generate respectable total return in a non-crashing market given a high enough leverage ratio. Under portfolio margin (PM) they can be leveraged up to 13:1 or more.

I don’t believe Reg T margin should be considered the real risk of these positions. T + 0 usually floats far above the expiration curve at significantly lower values of the underlying.

Nevertheless, I believe the Securities and Exchange Commission would say even as potential loss, Reg T margin must be acknowledged as real. This seems consistent with “your worst drawdown is always ahead” (mentioned here, here, and here).

Consider the following doomsday scenarios where Reg T margin could closely approximate [un]realized loss:

      • A nuclear bomb is dropped and the market opens down 1400 points
      • Alien invasion causes VIX to spike 100 points
      • NP trader killed by a drunk driver days before expiration as a market correction begins

Excuses might be good enough to rationalize personal losses but I would hold myself to a higher standard when managing wealth for others. I mean really… imagine conversations like, “I’m sorry that I lost your retirement savings, Mr. X, but:

      • My full-time job precludes me from watching the market intraday.”
      • That was a larger loss/volatility explosion than anyone expected” [LTCM anyone?].
      • The hurricane knocked my power out for a few weeks and I was not able to make necessary adjustments.”

None of these would ever be acceptable! Especially with the media refreshing the doomsday thesis on a weekly (daily?) basis, any professional should be aware of the possibilities and have contingencies in place.

The only case where I could accept such an excuse might be one where the risks were made totally clear beforehand. Salesmanship and persuasion are sometimes dubious practices where distraction and deception are used to make people agree to things without complete understanding of risk. I would therefore have to do more than gloss over the possibility of total loss. I would have to hammer it home by having them:

      • Listen to me repeat “you may lose everything” over and over and over again.
      • Write (pen and paper) “I understand that I may lose everything” 10-50 times.
      • Dwell on the catastrophic scenario and share their vision of a life following this catastrophic event.

I will continue next time.