Options Seller Risk/Reward (4)

The second risk is that the option the seller is long is going to expire approximately 30 days prior to the option the seller is short.


If volatility does not decrease or the stock does not move away from the strike significantly before the seller's long option expires, he/she will be left short a naked or un-hedged option and a loss on the position.


If the seller can wait out the position, the lost extrinsic value of the short option can be recaptured.


As we know, this option too has a limited life and must shed its extrinsic value, no matter how much, by its expiration.



The problem facing the seller is that the position is no longer hedged and the seller now faces unlimited risk.


Once the long option expires and the seller is left short a now naked call, stock price movement in the wrong direction is a substantial risk and under the circumstances described above, a big problem.


While the seller can wait out an implied volatility movement that created an increase in extrinsic value, they probably will not be able to wait out a large, negative stock movement creating an increase in intrinsic value.


In that case the seller must take action to prevent substantial losses once the front month expires.


Attention to the implied volatility in the farther out option when the nearer month option expires can save the seller from a large loss.