- Erik Billerikay
Selling naked options might be the worst idea ever | Worst Strategy
Updated: Jan 24, 2021
#option #backtesting #nakedoption #worststrategy
Selling naked option has been praised by YouTube Option guru as a high probability way to generate a weekly income. However, our historical backtest shows otherwise. Selling naked options might be one of the worst strategies that traders can trade. This article will show how selling naked options is a negatively skewed strategy and reveals how it might destroy your portfolio. We also include a strategy that we believe works well on SPY, QQQ, DIA in the end.
Why people sell naked options
Naked options are created when the option writer sells the option that he/she does not own the underlying security needed to meet the potential obligation that results from selling. When selling naked options, your account balance will immediately receive the premium paid by the option buyer. If the underlying asset does not move across the strike price, the option writer will not be assigned, and he/she will keep the option premium. Since the stock market is in consolidation most of the time, selling options is considered an income strategy for collecting volatility premium and time value.
The potential risk of selling naked options
The potential risk of selling naked options is, of course, be assigned. If the trader is selling naked put options, he is at risk of purchasing the underlying security at the strike price, which might be a significant markup to the current trading price.
A common argument claims that an assignment of naked put options is simply an opportunity to purchase the underlying security that the trader originally wanted to own.
Of course, in a bull market, stocks tend to pull back and then continue going up; thus, this argument might seem valid.
However, the real risk that we should be aware of is the tail event when the general market crashes more than three standard deviations, or in other words, the bear market. During bear market, option seller that can not escape will be left with owning down-trending stocks at a high price.
Billerikay believes data can tell a better story
We tested a naked option strategy on SPY with the following entry rules with our proprietary backtesting software.
On the 1st day of every month, sell one OTM call and one OTM put that are 5% away from the current trading price.
Exit on the last day of the month
The result is as follow:
By simple visual analysis on the portfolio's net worth, this strategy performed very well from 2013 to 2019. Same as we expected in a negative-skewed strategy. However, when the COVID shock came in March 2020, the strategy quickly fell apart. The COVID shock ripped away 7 years of steady gains from the strategy. It is likely that if anyone is trading this type of strategy during March 2020, he/she will experience similar drawdown to his/her portfolio.
Many large hedge funds trade naked options, and many of them do not exist anymore—for example, optionseller.com. As retail investors, it is important to understand our risk and trade accordingly. Billerikay believes that selling naked option is not a good idea for most people. Tell us about your thoughts.
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