Gain the Professional Trader's Edge by Understanding Risk.

10/26/09

NO. 3 RISK: LOSSES CAN BE INFINITE ON SHORT POSITIONS

Much like shorting stocks, shorting options naked (i.e., selling options without owning the underlying stock) can theoretically lead to substantial and even unlimited losses.

What makes shorting options (which is also known as selling volatility) tantalizing is the possibility of having infinite gains. Much of the professional investment world has achieved gains from selling implied volatility, as implied volatility has typically been higher than realized volatility.

If the previous sentence sounded foreign, do not spend too much time worrying about it. Bottom line: You should not go after naked short options often. But when you do it, it should be because you believe the risk-versus-reward balance is extraordinarily attractive and should be captured. To execute these types of trades, you will need to have Level 3 options trading clearance from your broker.