Managing Naked Options After a Technical Reversal
Summary
The document considers what to do after a naked put or call moves against the seller and the underlying’s chart outlook reverses. It compares closing the option, adding a protective option to form a vertical spread, and hedging with the underlying. For a short put, buying a lower-strike put creates a bear put spread and limits losses from a further decline; for a short call, buying a higher-strike call creates a bull call spread. Selling shares short against a put or buying shares against a call are described as delta-hedging alternatives.
The choice depends partly on gap risk and volatility pricing. If a sharp move is a concern, closing or spreading the position can cap exposure. If gaps seem unlikely, a trader who expects realized volatility to fall below implied volatility may continue delta hedging. These are conditional choices, not a universal rule: the document gives no empirical comparison, and its guidance depends on forecasts about future price moves and volatility.
Key ideas
- A lower-strike put can limit further downside risk on a short put.
- A higher-strike call can limit further upside risk on a short call.
- Delta hedging with the underlying remains an alternative when gap risk is judged low.
- The decision depends on expected gap risk and the relationship between implied and future realized volatility.
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Full text
# Naked options selling # Naked options selling I sold the naked put. The price of underlying went down and broke the support. The situation changed technically from bullish to bearish. The price of underlying is still quite far above the option strike. Should I buy back the option with loss or sell 100 shares short to cover it? What to do in the mirror situation with a naked call? I mean, when the price of underlying goes up and the situation changes from bearish to bullish. ## Answer by Iñaki Viggers (score 3) https://quant.stackexchange.com/a/44084 > Should I buy back the option with loss or sell 100 shares short to cover it? A better alternative is to buy a put with lower strike price (which would complete the strategy known as bear spread). That way you would hedge against further fall of that stock. Keep in mind that if you sell short and then the stock goes up, you would incur further losses. > And what to do in the mirror situation with a naked call? Buy a call with a higher strike price (thereby completing a bull spread). ## Answer by ZRH (score 3) https://quant.stackexchange.com/a/44088 I think the answer depends on your view on further risk of gapping down/up. If you think there is, you would either buy back the option or turn the position into a put spread / call spread, as @Inaki says. If however you believe gap events are unlikely, you would delta hedge, as you say. Implied volatilities are likely to have risen (on the back of the recent downmove), and if you believe realized volatility going forward will be lower than current implied, you would just keep delta hedging.
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