Las Vegas is an Excellent Short Premium Seller.

Sean McLaughlin
October 5, 2023

There are no free lunches on Wall Street and certainly not in options trading. 

It might be sexy to tell people that we’re “options premium sellers” and suggest that all we do is sell naked options that expire worthless – while keeping all the premiums for ourselves. Easy peasy.

But we know that’s not really how it works.

There’s a risk in holding naked short options. Our brokerage houses are keenly aware of these risks – and that’s why they require us to post margin in order to hold these positions. The margin protects the house. Mostly their house, but our houses too.

When a short options position goes against us, our brokerages need to ensure we have adequate buying power in our accounts to close the position and prevent further losses.

But just because we need to post a certain amount of dollars to hold a position doesn’t mean we should calculate our returns off of that number. That number doesn’t mean anything other than the fact that it’s the amount the house needs in order to be comfortable with us being naked short.

If we’re measuring our returns in naked short options trades based on our margin requirement, we’re going to be disappointed. We’re going to look at our possible gain in the trade and think to ourselves: “I’m risking $4000 to make $150? -- that reward-to-risk math looks terribly skewed against me!”

But in a naked short options trade, particularly when we’re selling out-of-the-money options and have a plan to take profits long before expiration, we are putting ourselves in a situation where we have a much higher probability of success than a typical long/short equities trade or long options trade. Depending on where we placed our strikes, we might have upwards of a 70-80-90% chance of winning our bet!

If Las Vegas offered you a 90% chance of winning, do you think they’d pay you a lot to take that bet?

Of course not. The options market is no different.

We have to take higher-than-average risks for the potential to earn outsized returns.  

When we’re talking about trades with high win percentages, the potential rewards will always be smaller. But the name of the game is to do them small, do them often, and be systematic about them. They won’t all be winners. In fact, we’ll have several losers that are larger than our average wins. But when we do enough of them over time, the edge plays out in our favor.

That’s the whole game with naked short options.

Trade 'em well,

Sean McLaughlin, Chief Options Strategist, All Star Charts

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