Naked premium selling involves selling simple calls or puts without having a position in the underlying asset or without hedging with additional option positions.
A typical example is selling SPY $117 March CALLS, currently trading for $.47 or selling SPY $111 March PUTS, currently trading for $.48. The maximum profit for both examples is the received premium. For the CALLS break-even is at 117.47 at opex; for the PUTS – break-even is at 110.52. The maximum loss is unlimited for the CALLs as theoretically SPY could rise to infinity in the next two weeks (I know it sounds ridiculous, but just pointing out the risks). The maximum loss for the PUTs is $110.52 per share as theoretically SPY could go to zero in the next two weeks.
Selling naked calls is an alternative to shorting. For example you might want to short certain stock, but there are no shares available to borrow or/and the IV of the Calls is elevated and you want to take an advantage of potential volatility crash;
Selling naked puts is an alternative to going long. For example you might want to go long certain stock, because it has declined significantly and for a “stupid” reason over the past month, but you are not sure how far the decline will go and you would like to take advantage of the elevated IV of the option. During severe and fast declines, options’ IV tend to increase significantly as fear has risen.
The general rule is to sell premium when you expect it to decline due to a move in the underlying asset, IV crash and time depreciation.
Premium sellers play the role of insurers. They offer the right to buy from them (via selling calls) or to sell to them (via selling puts).
Selling front month naked options is usually done to take advantage of elevated IV and accelerating time depreciation. Find an overextended stock with liquid options; stock that has declined significantly over the past few weeks. You would like to own at this level, but you are not sure if the decline will continue and how far it will go. Sell front month OTM puts to collect premium. If the underlying continues to decline, you will enter at much lower price in a stock that you would like to own at these levels. If the stock reverses up, you will keep a hefty premium as the IV will crash and theta and delta will be on your side.
Selling naked LEAPS (long-term options, typically having 12 months + till expiration). You find an overextended stock, to the upside or to the downside. If you sell front month OTM calls or puts, you won’t receive too much of a premium as there is not much time left till expiration. You are also not sure how far the selected stocks will go. In short-term perspective, irrationality reigns and anything can happen. Selling OTM LEAPS solves that problem. You receive a hefty time premium and in the same time you give the stock enough time to catch up with its fundamentals. In the mean time you could use the received premium to invest in other ideas.
Selling OTM LEAPS is one of Warren Buffett favorite strategies. After all he is in the insurance business. He likes to sell premium when there is fear in the market. In 2007 and 2008 he sold long-term index derivatives for $2.5 billion, betting that in the long-term the stock market tends to increase in value. Selling long-term puts of companies that he plans to acquire is also often practiced.
