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!” [Read more…]