This Day On The Street
Continue to site
This account is pending registration confirmation. Please click on the link within the confirmation email previously sent you to complete registration.
Need a new registration confirmation email? Click here

Should You Trade Options Naked?

TheStreet Premium Services

A complimentary preview
of Options-Profits Previews

Is there a reason traders should prefer risk-defined spreads over naked options positions? That question comes up pretty consistently in strategy discussions. In more detail, as one reader put it:

"What is the advantage of an iron condor over a short strangle, or of a vertical spread over just selling the desired put or call option outright? The strangle or short option will always have a bigger credit than the condor/vertical spread. Admittedly, you need to define a stop, but this doesn't seem to change the conclusion that the naked position will give you more potential profit."

The fact that a short straddle, strangle, or naked option offers a larger up-front credit in dollar terms is meaningless unless that credit is defined in relation to the risk in the position. Absent a quantified risk level, any comparison between a risk-defined spread (like a vertical spread or an iron condor) and an unlimited-risk trade (a short strangle or naked short option) is misleading. To achieve a genuine comparison, you would want to define a stop loss point for the strangle such that a closing trade at your stop level would incur a loss equal to the maximum possible loss on a similar condor. To make a comparison between a short call or put and a vertical spread, repeat the same process. Once those risk parameters are set, you should find that, repeated over time, the return profile over time of the naked options doesn't look much different.

In fact, the short strangle should look a bit worse due to higher path dependency: a preset stop level for your strangle or short put means you'll be taken out of the position once that level is breached, while the condor or vertical spread will have extra time to potentially profit from mean reversion back across that stop level.

Part of the added risk in a naked short option or a short strangle is the fact that your stops might not work as intended. Large price jumps occur overnight or even during market hours - think, for instance, of the flash crash in May 2010. I'm not a fan of hard stop orders resting on exchanges, but even a pre-set stop order sitting at the exchange may fail you in the event of an overnight or sudden intraday gap where prices move beyond your stop. Risk-defined option spreads don't face this problem, and that gives them a relative advantage.

Another advantage of risk-defined spreads is that they allow you to "lock in" certain levels of implied volatility (IV). If the underlying declines to your predetermined stop loss point, the price of the put side of a short strangle may be higher in IV terms than the IV of the options purchased when constructing a condor, making the strangle exit consistently more expensive on a relative basis.

Finally, a risk-defined option spread like a condor or vertical spread will have more favorable margin requirements than a short strangle or naked option position. Therefore, even if you structured a strangle with stop points such that it was synthetically equivalent to a condor in profit/ loss terms, and you knew the future such that there would be no adverse jump risk, the risk-defined spread would still be preferable from the standpoint of capital efficiency.

OptionsProfits can be followed on Twitter at

Jared can be followed on Twitter at

EXCLUSIVE OFFER: Jim Cramer's Protégé, Dave Peltier, only buys Stocks Under $10 that he thinks could potentially double. See what he's trading today with a 14-day FREE pass.

Check Out Our Best Services for Investors

Action Alerts PLUS

Portfolio Manager Jim Cramer and Director of Research Jack Mohr reveal their investment tactics while giving advanced notice before every trade.

Product Features:
  • $2.5+ million portfolio
  • Large-cap and dividend focus
  • Intraday trade alerts from Cramer
Quant Ratings

Access the tool that DOMINATES the Russell 2000 and the S&P 500.

Product Features:
  • Buy, hold, or sell recommendations for over 4,300 stocks
  • Unlimited research reports on your favorite stocks
  • A custom stock screener
Stocks Under $10

David Peltier uncovers low dollar stocks with serious upside potential that are flying under Wall Street's radar.

Product Features:
  • Model portfolio
  • Stocks trading below $10
  • Intraday trade alerts
14-Days Free
Only $9.95
14-Days Free
Dividend Stock Advisor

David Peltier identifies the best of breed dividend stocks that will pay a reliable AND significant income stream.

Product Features:
  • Diversified model portfolio of dividend stocks
  • Updates with exact steps to take - BUY, HOLD, SELL
Trifecta Stocks

Every recommendation goes through 3 layers of intense scrutiny—quantitative, fundamental and technical analysis—to maximize profit potential and minimize risk.

Product Features:
  • Model Portfolio
  • Intra Day Trade alerts
  • Access to Quant Ratings
Real Money

More than 30 investing pros with skin in the game give you actionable insight and investment ideas.

Product Features:
  • Access to Jim Cramer's daily blog
  • Intraday commentary and news
  • Real-time trading forums
Only $49.95
14-Days Free
14-Days Free
Top Rated Stocks Top Rated Funds Top Rated ETFs