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Always like to sell options that have extrinsic value. The option with the highest extrinsic value is always the “at the money” option.
You can see that it’s true, here. The time value and the highest Theta would be achieved by selling this option at the $75 strike price. You can see it’s not only true for the calls, but it’s also true for puts. This has a $3.55 extrinsic value on the put side. If we were to sell both of the calls and the puts at the money, we would achieve a fairly significant amount of Theta.
Let’s take a look at that. Let’s sell that, and let’s sell this one. We would achieve close to $7.20. That’s a significant amount of time value that we could collect, if we were to sell both of those options. In fact, that is the maximum amount of time value, and the highest Theta, that we could possibly achieve in this particular stock.
Let’s delete those for a second, for this month. If you put on a strategy like that, you could easily do it by going to “Sell, straddle.” You could see that, once again, gives us the mid-price of $7.50. If we took a look at the graph of this – let’s analyze this as a duplicate trade, and bring up our analyze tab.
You can see that if the price stayed relatively stable, we would have a maximum profit of close to $750. This is the amount of credit that we received.
It also has a fairly wide breakeven. In other words, the stock could move from approximately 67 on the down side, before we hit our breakeven point, or it could go to 82 on the upside, as our breakeven point.
It looks like the sale of a straddle – which is the most time premium that we could get, in the month of June – would achieve a very nice profit, if the price went up a little bit, went down a little bit, or stayed the same. We could achieve a very nice profit on this position.
The problem, of course, is that any time you are selling options, you are considered “naked” those options. When you are “naked” those options, you have a position in which you could have an unlimited loss. That is not a good position to be in.
Just to prove that is true, let’s shorten this price a little bit. I will show you exactly what happens. Here we are with the price. If the price were to move up to $90 and keep going, you could see that in fact, the losses would be incredible. Of course, in real life, you may not have those kinds of risks. A stock, theoretically, could go to infinity in price, but in reality, it probably would not.
You could see that, as long as we continue, we would lose more and more money in a linear fashion. If the stock went from 75 up to 500, we would lose $42,000. That’s not a pleasant situation to be in.
You might think, “That’s probably impossible. The stock at 75 would never go to 500.” However, I can think of a couple of situations, in which a stock at 75 could potentially go to 100 – 150, or more, resulting in a tremendous loss on these positions.
That is if the company is being bought out, is merging with another company, or an offer to buy the shares of the stock are made on that company. There are a number of factors that could affect the price of those options. If you’re “naked” those options, theoretically, you have an unlimited loss potential for those options.
That’s why we never sell naked options. We always do spreads. Now, if we wanted to capture the maximum amount of time value in these options, rather than just selling those options, let’s do the sale of a vertical.
We’re still selling the 75 call, to capture the maximum amount of extrinsic value. Now, we’re also purchasing a call, at the 80 strike price, to protect our position from having a huge loss that could potentially be unlimited.
Let’s also do it on the put side. We’re also going to sell a vertical. You notice that we have the same straddle that we had before, at the 75 call, and the 75 put. The difference is, we’re also purchasing a call to protect our position, and a put to protect the sale of our 75 put.
Let’s analyze these positions. Remember this graph? Let’s go back and put both positions on, creating a spread. The sale of a straddle, with protected wings. It looks pretty much the same as the other graph, doesn’t it? The profit potential is slightly less. Instead of making a maximum of $750, we’re only making a maximum of approximately $400.
Our profit is a little bit less. However, when you take a look at the potential loss – if we do get into a situation in which this company is rumored as a takeover target, and the price suddenly jumps from $75 to over $250 – it doesn’t matter how high the stock goes. Our maximum loss is only $109.
It doesn’t matter. This stock could go to 1,000, and we’re still only going to lose 100. That’s why spreads are preferred by professional traders, over the selling of naked options. To collect Theta.