Some short premium trades have undefined risk, meaning they have the potential for unlimited losses. Is this realistic?

First, we started by showing what "undefined risk" really meant by showing a distribution curve. Undefined risk represents the losses incurred if the underlying price were to increase indefinitely, well passed the 1, 2, and 3 standard deviation price levels.

If positions truly had undefined risk, brokerage firms wouldn't allow them to be traded. Brokerage firms (and exchanges) have margin requirement rules that are based on probabilistic outcomes. The firms will generally price the risk of, for example, a naked call, at a 2 standard deviation move. This move only occurs about 5% of the time (including upside and downside movements).

What that tells us is that 95% of the time any losses should be less than they would be at 2 standard deviations. The next step then is to determine the magnitude of a 2 standard deviation move. Since an underlying has an approximate 2.5% probability of settling beyond a 2 standard deviation move at expiration, we look to the 2.5 delta options to find the 2 standard deviation strikes.

A table of the 2.5 delta options in the QQQ (Nasdaq ETF) March options with 51 days to expiration (DTE) was displayed. An example of the 2 standard deviation losses when selling a straddle was used.

Watch this segment of “Options Jive” with Tom Sosnoff and Tony Battista for the valuable takeaways and a practical way to quantify the risk on undefined risk trades.