April 21, 2020 - (Gold Market Wire) - Are You “Naked”? Part II

A person is considered“naked” in the market when there is no offsetting position. It's really that simple.

Some examples may help, and the first we will give, from the options world, reveals the opposite of “naked”, which is why its called “covered”. It is the simplest of option strategies and is called the “covered write”. (an option writer is the seller – like in the world of insurance policies - where there is a “writer” and “underwriter”)

In a “covered write”you buy the underlying and sell an equal amount of out-of-the-money calls. Now you are “covered” 1:1 - i.e. - not “naked”. If the market screams north against your short option position, instead of being financially destroyed by the trade, you have neutralized the risk. At the strike of the short option the P+L goes flat. There is no further exposure. However, it is the “write”, i.e. the short option, which is covered. It is not the underlying that you are long that is covered. That is covered only to the amount of the premium received through the option sale. Ergo the name “covered write”.

The reason it is called a “covered” write is because it is not “naked”. It has an offsetting position against it. It is a strategy with two components. If you think this is simply a matter of perspective, you don't know how a clearing firm works. They margin on the position. 500x spreads have less margin that 50x “naked” futures. 100s of covered writes can use less margin that 10x “naked short” calls approaching the money. In the covered write, if the “underlying” (stock, commodity, whatever) goes to zero, you will lose everything - minus the option premium received.

In the real world of trading, the dialogue sounds like this:

Broker: “Hey man, I got June $1850 calls here, straight bullet option.”

Trader: “OK, naked or with Delta?”

Broker: “Naked.”

Trader: “Ok, let me see where I can hedge it first.”

When you buy a stock in your portfolio you are “naked long”, save for dividends. If the stock goes to zero, it's all gone. (This is what the public does, which is another reason they usually lose money; no risk management skills.) Stock Brokers don't do much margin business anymore, since 'flash crashes' became regular occurrences. They'll only provide margin if you have a big cash account they can drain at will. In a margin account, once the stock starts tanking, you'll either be closed out, or the demands for immediate cash will soar. The most horrific scene, for traders watching, the famous film "Trading Places" was when the floor official walked up to the Dukes and said "Margin Call Gentleman." Where the hell do you lay off FCOJ risk when the market just closed? (Have you ever wondered why so many soft commodity traders look so old, so early in life?)

‍

Here's another example, again in options, with what is called a 'call spread'. The initiator of these is usually buying the closer to the money option and selling a higher strike, and the seller often comes in two counter parties, or a market maker who already has one or two of the strikes on his book in opposition. In this example, using the Gold market, you, the call spread buyer, buy the December $1700 call and sell the December $1750 call - at the same time - if you are smart. That doesn't make the $1750 (short) call “naked” - because it's part of the call spread.

However, if you try and “leg it” and you get away the short option first without achieving the spread, your trading manager (or clearing firm) will be on top of you in minutes asking if you are crazy and want to be fired/closed out. That is because you are “naked”. Option trading managers always insist that the long option in the spread be established first if you are trying to “leg” your way in to it. (They also insist on hedges for roughly 95% of the book, because nakedness is seriously frowned on.)

In the underlying (read 'futures') market, the spread trader may try and leg parts of the calendar (one month against another) for a few minutes, but it is rare, and if he misses, he will be forced to cover - at a horrific price usually. Locals and desk traders trade the curve - the differential between one month and another. Sure they can “go naked” for a while, as in a few minutes, but never for long before they cover. If people think commodity traders, even pit locals, are just swinging long or short positions around, then you really don't understand the market.

Here is a another,“non-naked” example.

Buy June/Sell December.This is most common trade in commodities, after the buy front month/sell second month, which is the most common oil trade there is (we won't go into CFDs today – but be assured, that's just another spread).

When you buy one month and sell the other those two trades have “correlation” and that correlation is high, almost always 90%+, (although gold just recently revealed the other 10%). The short side of the spread (i.e. - the month you've sold) isn't “naked”, because it's offset against being long another month. The back months, i.e., the illiquid trades of the commodity world, are offset against the liquid nearby month. No professional trader is simply trading the deferred months outright without doing the opposite in the front (i.e. - the "front to back"). The people buying and selling the deferred outright are mostly funds (ETFs) and they have the customer position against it.

The annals of ex-commodity traders are rife with people who thought they could achieve glory by trading spreads and trying to squeeze pips by“legging”. If I had a dollar (ok, make it a tenner) for every time I've heard the story, “That idiot got fired for trying to leg spreads,” I'd be very rich indeed. Legging means going “naked” for a period of time, and sometimes you get your “shorts” on only after a lot of 'exposure'. That's why spreads trade as spreads. Legging is for lunatics – because it leaves them naked.

Long-term oil trades – for example - always have another component to them, and that's why June/December, June/June, and Dec./Dec. are so active. They hedge the one-year swaps (Dated Brent-vs. One Year and vanilla OTC swaps). Moreover, exchanges don't report the trades in different jurisdictions, so you have to do the work yourself, and usually make an educated guess. Sure, it might look like one segment of the industry is “naked” short WTI, but that's because they are long Brent...and not necessarily in futures. It could be in the cash market or the swaps market. The complexity of spread trading is how professionals make money. That's why it's called trading.

On the physical side, if a refinery sells strips of middle distillate futures or swaps without any other position in the market, is that short “naked”. No, it's not. They have refinery throughput, which means they process crude oil and create the product they are shorting, i.e.- selling. It's a forward sale of the product they create. If a gold producer sells forward, it's not a "naked" short, its a forward sale on production. But, in the case of mines, they have to actually have the production they've sold against. The problem in the Gold mining world is that the taste of forward sales (especially in the form of OTC Derivatives) is so addictive companies start selling more than they can produce, which leaves them net short... i.e. “partial nakedness”.

So when people talk about being “naked short” you first have to know what the term means, and how it is used within the industry.

I hope this explanation has helped.

‍