Risk/reward of writing deep OTM naked calls on SPY

Discussion in 'Options' started by trader13682, Dec 17, 2011.

  1. I was wondering what is the risk level of writing deep OTM calls on an index such as SPY.

    For example, the current price for a $150 JAN 18 2013 call on SPY (european-style option - so exercise is on expiry day only) is around $1.90. So, that is around around a 380 day holding period and assuming a margin of 10% * $122 = $12.2 (or $1,220) per sold call) required, that translates to an effective 15.5% return (or 14.9% annualized).

    If the SPY were to start to creep up in price prior to expiration, I could avoid taking a loss (realized or unrealized) by simply buying 100 shares of the underlying (SPY) in the open market, to turn the trade into a covered call and effectively close the position (as opposed to buying back the sold call at a higher price which would turn into a realized loss), and then sell the SPY after the expiration date. It would be highly unlikely for SPY go gap up by 20% in one day and in any case I could always buy the SPY shares in the market to cover since this is an european option.

    This means that I would keep on hand 100 shares * $150 * 50% initial margin = $7,500 of capital for each sold call in the unlikely scenario in which I had to convert the naked call into a covered call (or lower capital if portfolio margin is used). In this scenario, my only real risk would be that the price of SPY first goes way up, thus compelling me to turn the naked call into a covered call, and then goes way down prior to the expiration date.

    Is this concept of being able to close out the position without taking any loss by simplying buying the underlying at the current market price 'too good to be true' somehow? Did I miss something in my analysis?
  2. FWIW, SPY is American not European exercise.

    IV can increase dramatically thereby causing margin requirement to increase (not a problem for you since you're escrowing 50% cash).

    Your risk is that once you buy the SPY shares, all it has to do is be $1.90 at exp. and you're a loser.

    And while the odds of it going "WAY DOWN" are small, take a look at a 380 period in '07-'08 when the SPY went from 140 to almost 160 and then down to 120. It does happen.
  3. daveyc



    as spindr0 mentioned, this is an american style option. but it doesn't matter. i don't think this trade is without substantial risk. spy can move in both directions in a hurry, so you could potentially lose big on the short calls and then lose big on the spy shares and then wonder what the heck happened.

    consider covering the short calls with longs (spread) instead or better create a back ratio especially if you are using portfolio margin. and if you happen to have pm, use spx instead.

    i think both covered calls and naked shorts are too dangerous in this or any market. good luck.
  4. 1) You'll have to "sweat out" 380 days of waiting to capture the entire premium. :eek:
    2) The option premium will decay very slowly but potentially "spike up" quickly as others have mentioned. :(
    3) If you convert the position to a covered-call, the delta of the short-call option is still likely to be "small". Your position will now more closely resemble a short-put option much closer to, ATM, at-the-money. :mad:
    4) Instead of shorting a 12-month dated option, one time, you may be better off shorting a 3-month dated option, 4 consecutive times. :cool:
  5. In regards to #4, writing the calls in 3 month increments versus a single 12 month increment seems to have the following 2 disadvantages: (1) it would involve 'paying' the bid/ask spread 4 times instead of 1 and (2) it would require the call strike price to be a much lower # (EG: 10% above current price) versus say a 20% above current price strike for the 12 month, which on a fundamental analysis level, will be harder for the UL to reach.

    Are these 2 disadvantages outweighed by the faster time-decay enjoyed when writing the 3 month calls versus the 12 month?
  6. 1) Yes. (Confirmation of the obvious)....time decay is more "severe" closer to expiration.
    2) Compare at-the-money and slightly-out-of-the-money option premiums at 3-months and 12-months to get a better idea of the ratio of the premiums.
    3) (Confirmation of the obvious), longer-dated options have greater volatility sensitivity which will tend to work against "shorts", another reason to consider a shorter-dated option. :cool: