Consider the following example. If I sell out-of-money Google calls (say May 590 for $4.40), and GOOG advances near 590 (it is currently at around 550), what do I have to lose if I place a limit buy of the stock at 590? I understand that the moment I buy the shares I would be exposed to the downside, and that I would also have to keep the necessary margin in my account in order to buy the stock. I also understand the opportunity cost due to giving up any upside when I buy the stock to deliver. Other than those considerations, are there additional costs/risks I am missing? If not, it seems to be a reasonably conservative "income generation" strategy (about 10% a year compounded, assuming full margin allocation for each such trade). Sorry for asking what is obviously a newbie question. Thanks.
How much stock are you planning to buy at 590, in proportion to the size of your short option position?
If you wait until GOOG is near $590, you'll have to purchase a lot more shares than you anticipate to hedge your short calls. Leaving you exposed to the downside, as you said. Unless moving through $590 is a clean breakout, you'll have to deal with choppiness in the underlying. You probably want to put this in the options forum. You'll also want to download thinkorswim, optionvue or some other option trading platform to plot the risk graph.
Well, if I am buying purely to hedge, I would have to look at the delta, which would have to be around 0.50, meaning 50 shares for each option. But the spirit of the question was more along the lines of "I will just buy the darn shares at the promised price and get ready to deliver them", which would mean full 100 shares per option. Presumably, if the stock runs from 550 to 590, it would take a while (so close to expiration date), and have a reasonable momentum, mitigating the downside risk. But then, I don't know much.
You are right. I probably should have put it in the options forum. Too late for that. But, from the two quick replies (thanks!) I take it the market risk at the time of "buying to deliver" is the only risk involved. Thanks for the replies, Kedwards and Martinghoul.
You're correct... Assuming you care only about your PNL at expiry, there are no significant risks to being short options, other than the risk of losing money due to the movements of the underlying. There is one thing to be aware of, although it's not very likely to occur for a liquid security. Specifically, being short an option exposes you to liquidity risk, which is not easily quantifiable. In your case, imagine GOOG instantly jumping from 550 to 700, without allowing you an opportunity to delta-hedge. This is a risk that most option models assume away, with good reason. Still you need to be aware...
I would not wait until 590 to hedge not would I buy 100 shares per naked call. I would delta hedge, buying more (or less) shares based on my bias. With the shares in place, you could gamma scalp any choppiness in the market.
You are probably an experienced options trader, and I am sure it works for you, and hopefully for me some day soon. But my concern was more pedestrian, namely, as a newbie, am I missing anything other than the downside risk in the shares I buy at the strike price for the purpose of delivering them. Now, I am assuming that this will happen very close to the expiration. If not, I understand that I need to delta-hedge. I have read that perfect delta hedging is a zero-expectation activity, and the transaction costs, as well as the finite steps, make it negative. Better than having my head handed to me to be sure, but I am not very enthusiastic about delta-hedging as I was earlier. I still have a ton to learn. But I suspect that experienced traders make their money from directional bets (including no-direction) as well as spotting price anomalies. Those, and especially spotting options price anomalies are beyond my grasp at the moment. As for gamma-scalping, I need to learn more about it before I can begin to comment on it. So, to me, the take-home message (for trying to make money from selling OTM calls) seems to be: If the price approaches the strike close to the expiration, start buying the underlying according to current delta, and buy the whole 100 shares if the price strikes, and endure the 0.5 delta risk for the remainder of the expiration (say a day or two). Hopefully the shares don't turn around and plunges like a rock right before assignment. If the stock turns around, reverse sell back in the same rate as on the way up. If all goes well, I keep the premium, minus the commissions, and maybe a bit of stock appreciation. If the price approaches the strike early, with many days/weeks left to expiration, try to delta hedge, with a view to minimize losses, but expect to lose some money. With more experience, do as spindr0 says ;-) Let me know if the above sounds sensible. Thanks for the reply.
But I am trying to go to expiration, rain or shine, so whatever happens to the option in the meantime, it will be zero at the end. What I wanted to get some intuition on was the amount of risk one is undertaking, if one is prepared to fulfill the promise in the contract. It doesn't seem to be that big, unless of course the stock gaps up hugely for some reason, as was pointed out earlier. If one is reasonably assured of an orderly change in prices, there seems to be less risk than the reward (I will learn first-hand if I start trying). Black swans are much more probable in the downside, I think. So I would never do naked put selling for that reason.