Short options trades (specifically naked short options trades) are considered by many traders to be the trades with the highest risk. As usual with popular opinion, this is incorrect, and quite the opposite is actually true.
What are Short Options Trades?
Short options trades are trades that are entered by selling options, and more specifically by selling options without the opposite trade in the underlying instrument. For example, selling a call option that is based upon an individual stock without owning the underlying stock would be a short options trade.
Why are Short Options Trades Considered Risky?
Short options trades are considered high risk because they have limited profit potential, but unlimited risk potential. In other words, short options trades can only make a relatively small amount of profit, but they can incur any amount of loss. For example, a short put option can only make its premium (i.e. its cost) in profit, even if its underlying stock goes up 1,000 points, but the option can lose any amount (e.g. it would lose 1,000 points if the underlying stock loses 1,000 points).
The Truth About Short Options Trades
The truth is that short options trades are no more risky than any other trades. Even if short options are traded badly (i.e. no stop loss, held until they expire, etc.), they are still no more risky than most stock trades.
The following is a comparison of two trades, made on the same underlying stock (XYZ), at the same price $45.50, and in the same direction (long), showing the risk that is associated with each trade:
- Individual Stock Trade
Stock XYZ is trading at $45.50, and a trader makes a long trade by buying 100 shares. The trader uses approximately $1,350 of their trading capital as margin, and has $4,550 of their trading capital at risk (i.e. the value of the stock).
- Short Options Trade
Stock XYZ is trading at $45.50, and its put options with a strike price of 45 and a time frame (i.e. expiration) of 90 days, are trading at $4. A trader makes a short options trade by selling 1 put option (the equivalent of a long stock trade with 100 shares), and receives $400 in profit. The trader uses approximately $1,000 of their trading capital as margin, and has $4,150 of their trading capital at risk (i.e. the value of the stock minus the put option's premium).
As the above trades show, the short options trade actually has lower risk ($4,150) than the long stock trade ($4,550), yet long stock trades are considered low risk, while short options trades are (incorrectly) considered high risk.
Note that this is a very simple risk analysis, and while it is correct (i.e. short options trades are lower risk than buy and hold stock trades), it does not include any risk management (e.g. well placed stop losses, risk to reward ratios, etc.), so it is not complete enough for trading purposes.