One message I get a lot is that people are afraid of options trading - and selling options in particular - because of infinite loss.
Yes, infinite loss is possible in one very specific scenario (which I never use), but in fact using options almost always reduces your risk compared to buying stocks outright, so I’ll talk about that today.
Before we get started, if you're new or would like a refresher on my options strategy, I strongly recommend reading my options strategy primer at the link below.
This week:
Let's talk about "infinite loss"
Here is a direct quote from Investopedia:
“When you sell an option, the most you can profit is the price of the premium collected, but often there is unlimited downside potential.
When you purchase an option, your upside can be unlimited and the most you can lose is the cost of the options premium.”
I don’t know about you, but any sane person reading this immediately thinks “screw that unlimited downside potential, I want the unlimited upside - I’m going to buy options”, right? Wrong!
There are only 2 types of options - puts and calls. All the trades I’ve talked about previously are selling puts.
Let’s compare buying Apple (AAPL) stock, currently trading at just under $166, vs selling options on AAPL stock.
Stock trader Steve decides AAPL is a good buy today, and buys 100 shares for $16,600. Option trader Owen decides he wants to own AAPL at a lower price and sells the $155 put expiring on 16 September (he promises to buy 100 shares at $155) and receives $245 in premium.
On Monday when the market opens, AAPL announces bankruptcy and the stock falls to $0 (this probably wouldn’t happen, but let’s pretend).
Stock trader Steve is instantly out $16,600. It’s not coming back.
Option trader Owen still needs to make good on his promise to buy stock at $155 (even if they are currently worth $0), so he pays $15,500 for 100 shares, minus the $245 he received - so $15,255.
This is basically the same trade - two investors who wanted to own 100 shares of AAPL, but went about it differently.
When crap hit the fan, the stock owner lost $1,345 more than the option seller.
Two takeaways:
1) As a put option seller, the most you can lose is if the stock goes to $0. Last I checked, that’s not infinite. In fact it’s the same risk profile as someone who buys stock directly.
2) Because you’re never buying stocks at market prices, you will always be better off financially if the worst case scenario happens (I’m sure in effect this will be little comfort, but objectively it’s true).
Ok, so when can infinite loss happen?
The one specific case where infinite loss is a thing, is in selling naked calls.
That’s the reverse of selling puts and you’re promising to sell 100 shares of a stock at a set price.
Why is it infinite? Well let’s say stock XYZ is trading at $100 and someone sells a naked call at $105 and maybe collect $200 premium.
They are promising to sell 100 shares of XYZ at $105 - which they do not own (hence naked call).
The thought process here is that they don’t think the price of XYZ is going to increase to $105, and so they can keep the $200 premium.
However, let’s say XYZ has some ridiculous breakthrough, like discovering hyperspace travel. That stock shoots up to $200.
The option seller is still on the hook to deliver 100 shares at $105. So they’re going to have to go into the open market to buy 100 shares of XYZ for $200 (that’s $20,000), and then selling it for $105, an instant loss of $9,500.
The reason why it’s technically labeled as “unlimited'‘ is because the stock could in theory keep climbing to $500 or $1,000 or $2,000 dollars - which in reality would likely bankrupt the option seller and result in a complete loss.
I’ve gotten burned with naked calls and as a result that it the one options strategy I never touch and never recommend - but I hope this addresses some (if not all) of your worries about the possibility of “infinite loss”.
tl;dr - don’t sell naked calls and you will never risk infinite loss.
Trade update: ABBV, KMB & PG
For an in-depth explanation of why I entered these trade, check out last week's article.
Last week I said it was rare to see Proctor & Gamble (PG) down 6% in a day. And indeed, this week the stock bounced back 4.66%
With that, the option premium also shrank (remember put options get more expensive as the stock price goes down, and cheaper as the stock price increases).
By Thursday it was only worth $0.89, and I closed the entire trade.
Sorry if that’s really small, I’m taking screenshots from the desktop version of Tastyworks.
Basically I received $200 in premium and used $89 of that to close the position, resulting in about $110 in profit after fees. That’s 55% of max profit in 4 days - I’ll take it!
Not all trades are doing as well.
ABBV was put on for $200, it’s currently trading at $310 ($110 unrealised loss)
KMB was put on for $210, it’s currently trading at $150 ($50 unrealised gain). Not bad, but not at my profit target yet.
One point I made last week was it’s much better to have 1 contract in 3 different stocks, than 3 contracts in 1 stock, and I think it’s pretty clear why.
After one week we have 1 win, 1 smaller win, and 1 unrealised loss.
I’m not smart enough to know which is going to be the win beforehand, so I like to spread out the risk as much as I can.
Now I’m down to 2 trades with 41 days till expiry, lots of time to make profits.
Speaking of time, there are 2 trades where time is running out with only 13 days to expiry.
Trade update - WBA
For new subscribers, at the top you have the name of the stock, Walgreens (WBA), as well as its closing price on Friday, $38.99
Circle 1 contains all the option details. Reading from left to right, it shows I have 2 contracts expiring on August 19, which is in 13 days, at the $37.50 put strike.
Circle 2 is how much one option is currently worth, 33c. Or actually $33 - because remember each option contract controls 100 shares, so the number needs to be multiplied by 100.
Circle 3 is the trade price - $1.22 or $122.
So this trade has already hit 73% of max profit ($122 - $33) / ($122).
Ordinarily with 13 days to go, I’ll take the 73% profit and call it a day. It’s not worth holding on for that extra $33 and risk the trade turning to a loss when expiration comes (it wouldn’t require much for WBA to drop $2 to $36+, and then the trade is in the money).
But as I mentioned last week, because I already have 200 shares of WBA, I’m looking at possible assignment of another 200 shares at $37.50 as a way of lowering my average cost basis.
I do have an order working to close it at $15 - we’ll see it that gets hit this week.
If you notice, I’ve almost been repeating myself for the last 3 weeks for this trade.
That’s what selling options is like. A lot of it is going in with the best trade possible, and then waiting for time to pass and option premium to decay. This isn’t day trading!
Trade update - SCHD
For SCHD, it’s pretty much the same story.
Last week the option was trading for $50 (70% of max profit), this week it’s at $30 (82% of max profit).
Remember that this trade was a losing trade back in July, and I had to roll this position out to August to buy some time for the stock to recover.
Turning that from a loss to a $141 win in a month isn’t too bad. Let’s hope I haven’t jinxed it with 13 days to go.
Same as with WBA, I already have an existing position in SCHD at $78, so I’m open to getting assigned at $73, which will lower my cost basis to $75.50 a share.
I have an order to close this at $15 as well.
This article is for educational purposes only. This is my own portfolio which is being managed according to my goals and risk tolerance. Your situation is likely different and you should do your own due dilligence before investing in stocks or options.