Overview: There are serious risks involved with some of the popular option trading tactics commonly being used and taught today. Here’s why Naked Puts and Credit Spreads tend not to fare well given today’s typical market volatility.
If you’re like most option traders you’ve likely had some successes. You’ve also very likely had some equal or more significant failures. You’re not alone.
If you’re like most option traders you’ve traded using short puts. This is where you sell a put, collect a premium, and then hope the underlying price doesn’t move. The general idea is that you wait for the option to expire without any worth, cap your premium, and begin your next trade.
This sounds good and seems to make sense but things don’t always go as planned. Everyone knows this but option traders have a particularly keen awareness of this basic fact. When the price goes down, sometimes way down, you can make some defensive adjustments, but if the price continues to drop you’re really just locking in your losses.
As a variation on this theme, you can trade a put spread, in an effort to minimize your potential for loss. But a deep look reveals the same basic structural limitations. Once you again you’re selling a position, buying a position, collecting a premium and hoping the price stays above your credit spread.
The problem remains that the underlying price doesn’t always do what you want it to do. As the price drops, you can make some adjustments but you’re already eroding the small premium you collected. You also maintain a significant risk so that if the underlying price continues to drop you’re just going to lock in more and more losses.
Losses just like this are terribly common with these kinds of trading tactics.
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