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HomeFutures & OptionsNaked Options vs Option Spreads: A Comprehensive Guide For Traders

Naked Options vs Option Spreads: A Comprehensive Guide For Traders

Have you ever encountered a dilemma between purchasing a naked call option or opting for an option spread based on your market outlook, whether it leans bullish or bearish? Options offer the flexibility to either directly buy a single call or put option, or devise a straightforward or intricate strategy in response to market behavior.

Investors are drawn to trading options due to their cost-effectiveness compared to futures. Options provide advantageous leverage where a small capital investment can yield significant returns through options contracts. Naturally, while there are several benefits, there are also associated drawbacks. Alternatively, buying options within a spread—whether in a 1:1 or 2:1 ratio, or through numerous other strategies—requires knowledge, expertise, experience, and of course, a financial commitment.

In this article, we will delve into the comparison between naked options and option spreads to determine which might be more suitable for a retail investor.

Naked Option

Purchasing a naked option involves acquiring an option without any accompanying hedge, presenting an opportunity for rapid profit-making while demanding less capital compared to the options spread. For instance, if considering buying an at-the-money call option for Nifty, currently trading around 21,650 levels, priced at approximately Rs 142 per lot with a lot size of 50, the cost per lot totals around Rs 7,100. With a capital of Rs 10,000, one could potentially buy 1 or 2 lots of Nifty options if the prices are less for the options contract.

However, it’s crucial to note the impact of decay on options. If the underlying asset doesn’t move favorably, the anticipated gains may not materialize as expected due to the decay in option prices. For instance, buying a call option at Rs 50 when the market is at 21,600 at 10 AM, and if the market remains sideways for the next 2 hours, the option value might decline due to time decay.

With naked call options, the profit potential is unlimited, while the loss is capped at the total cost of purchasing the options contract, in this case, Rs 7,100 which attracts most of the retail investors.

Considering the Greeks, if holding the option until the next day, theta becomes a risk factor. Increased volatility can lead to profits, but a decrease in volatility might result in losses for the option. Therefore, the decision to opt for a naked option hinges on the anticipation of a swift or sudden market movement without consolidation within a range.

Read: Mastering Implied Volatility Crush

Option Spread 

Options present a good or safe approach to trade momentum compared to buying naked options. For a bullish outlook, creating a bull spread or a bear spread for a bearish perspective is a viable strategy. However, compared to naked options, spreads necessitate more capital.

For instance, in a bullish scenario using a bull spread, one could simultaneously purchase an at-the-money (ATM) call option while selling an out-of-the-money (OTM) call option. The sold call option signifies the level at which the market is anticipated to reach. Contrasted with naked options, a spread limits both profit and loss, but it offers the advantage that even if the market remains stagnant the next day, profits can still accrue if the market aligns with the prediction.

Also Read: Understand Shorting OTM Call Options Strategy

Opting for an option spread is ideal when anticipating market movement without certainty about the exact timing. If one foresees target levels within the next couple of days, creating an option spread becomes an attractive strategy. Various options and strategies exist, demanding knowledge, skill, and experience to craft and adapt according to prevailing market conditions.

Conclusion 

A trader should consider buying naked options contracts when an instant market move is expected, not solely due to having less capital for trading and the expectation of doubling capital in one trade. Conversely, if you hold a market view that it will reach a specific area within the next couple of days, and you lack sufficient time to be constantly in front of the screen, choosing options spreads could be a viable option. Nevertheless, it necessitates more capital than buying naked options contracts. Rest knowledge of Greeks is an advantage for a trader trading either of the options strategies.

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