It doesn’t make any difference whether you have any personal interest employing options or not. You do need to know how they can impact markets, particularly on Fridays, quarterly expirations and month-end. Everything that follows is focused on naked or unhedged option writers. For this example, I’m going to use naked or unhedged call option writing. (Naked put writing is the mirror image).
If you have written a naked or unhedged call, your position is the same as being ‘short’. If the market starts to rally against you, you can:
- Sustain a large loss by doing nothing,
- Stop the loss through an offsetting purchase or
- Buy futures. If you buy futures it is possible to get whipsawed.
In last weekend’s client report I attributed Friday’s rally to naked or unhedged call option writers following the release of the FOMC minutes on Wednesday afternoon and early downside futures follow-through on Thursday morning.
In preparation for trading on Friday, May 10, I wrote in the Morning Report:
“WEEKLY OPTIONS EXPIRATION
With the market hitting new lows, the potential for option writers to have sold or written naked or unhedged calls is high. Last Friday, this phenomenon was partly responsible for short covering throughout the session. The above is not meant as a prediction but rather as a possibility.”
OPTION WRITERS BEHAVIORAL MINDSET
In any competitive skill-based undertaking, it is extremely important to understand the behavioral instincts of those you are competing against. Volatility, as measured by the VIX has risen sharply over the past few days. With increased volatility comes expanded options premiums.
At 10:40:46 EST, with futures selling at approximately 2831.50, the 2855 call options, which expired at the close, were 24 handles out-of-the money. I purchased the calls for 4.70 points ($235) from an options seller. The last trade on the calls was at 32.00 points ($1600) (I didn’t hold them until the close).
Based on experience, I believe the mindset of many of the option writers was that this was found money and all they had to do was hold until the close to pocket their winnings.
I believe that naked or unhedged option writing is the single worst strategy you can employ. Most often you do pocket the money, which I referred to as nickels and dimes. When the strategy doesn’t work your losses are in large bills.