Options for Rookies

The Care and Handling of Covered Call and Naked Put Positions

Hi Mark,

Thanks for presenting this article on a topic related to covered calls.

Steve's question, as well as the oft repeated discussions on the JustCoveredCalls Yahoo Group regarding whether to (1) close or (2) roll; short puts (in the case of cash-secured puts [CSP]) or short calls (in the case of covered calls [CC]) leads me to conjecture that there is an insignificant difference concerning the "What to do?" question when one compares the comparable decision facing either the CC or the CSP writers.

2) In a related (albeit different) line of inquiry, it seems to me that individual investors who are put writers might be slightly more conservatively oriented in that they tend to sell out-of-the-money strikes whereas covered calls investors are more likely to be somewhat more aggressive in that they seem to have a greater tendency to sell out-of-the-money calls.

Do you have any thoughts on this question?

Are you aware of any academic research in this regard?

Best Regards,
Jeff

***

1)  Although I've never seen a discussion on this question, it's makes for an excellent blog post:

Let's assume that the reader of this post already understands that covered calls and CSP positions are equivalent (if you are not certain this is true, here's evidence).  That means they offer essentially identical profit and loss profiles.

Do the covered call writer and cash secured put (CSP) seller face essentially identical decisions?

Let's assume the trader is short RGTO Jun 40's.  The covered all writer owns the shares and wrote Jun 40 calls.  The CSP trader sold RGTO Jun 40 puts.

a) When the stock is near 40 as expiration nears, each is faced with a similar decision:

Do you exit the trade, eliminate all risk (associated with significant negative gamma)?  Is this decision affected by whether the position is profitable? 

Do you hold because theta is relatively large with a decent daily reward?

These decisions are identical. The put and call options have the same gamma, vega, and theta.  The positions have identical risk and the traders face identical decisions, even though they don't necessarily recognize that fact.

i) If the traders decide to exit, they make the same decision.  There's not more to say about that choice.

ii) When the CC writer rolls the position to the same strike in July, he/she is selling the call time spread.  The new position is the RGTO Jul 40 covered call.  That position is equivalent to being short the RGTO Jul 40 P.

When the CSP seller decides to roll the position to the next month, that trader also gets short the Jul 40P. 

Thus, each makes the identical play: changing the Jun position to Jul and each has a position equivalent to the other. 

iii) This is a constant.  Regardless of the strike price chosen - as long as each trader sells a RGTO option with the same strike and expiration, each makes an equivalent trade when rolling and each owns an equivalent position.

b) If the stock is not near 40, then either the call or put is relatively DITM and the other is FOTM.

i) If the stock is > 40, then the CC writer is assigned an exercise notice, has no residual position and earns the maximum possible profit for that trade.  The CSP writer sees the short put expire worthless.  This trader also has no residual position and earns the maximum.

ii) If the stock is well below 40, each has a losing situation - but it's the equivalent.  Each has lost an equal amount of  money.  One reasonable action is for the call writer to sell the Jul 35 call - either after the Jun option expires worthless, or prior to expiration.  Why prior?  To collect extra cash NOW, and not gambling on the stock price change between NOW and expiration.

It's also common for the CSP seller to 'roll down' by covering the Jun 40P and selling the Jul35P.   If that's the decision, then once again each has made the equivalent trade.

Bottom line:  Jeff, I agree with your premise: "there is an insignificant difference concerning the 'What to do?' question."

***

2) I also believe it's true that most option sellers feel safer when writing OTM options.  That would leave the CC writer selling options with a higher strike price (calls) and the CSP writer selling lower strike price puts.

Why does this happen?  In my opinion, it's a result of covered call writers not quite 'getting' the idea behind their strategy.  The need to have a chance to earn a profit on a rally (call it greed) overwhelms their need to minimize loss potential.

Using a $40 stock as an example, if the CC writer understood that writing the Jun 45 call resulted in a position equivalent to selling the Jun 45 put (when it's five points ITM), he/she would be horrified.  Yet, unaware of this equivalence, they write OTM calls month after month.

3) I am not aware of any academic studies, but Odean and Barber have written many papers about the investing habits of individual investors.  If you write to one of them, you may get a reply (I did).

625

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One Trader's Thoughts on a Dividend Capture Trade

Jason sent an example in reply to this Q & A.

An example. Pfizer is going ex-dividend next month. Paying $0.18 div and currently trading at $18.50. March 18 call selling for 1.10. Break-even of stock minus div and premium of 17.22.

If called 4.13% earned, if uncalled 6.84%.

Sell stop limit on shares at 17.22 and buy back the call (not sure what this would cost, so don't know how to include for further loss.

***

Thanks for the example Jason,

I'm asking questions below.  I'm NOT looking for answers.  I just want to be certain you think about this and have a plan.

I believe your prices are not accurate.  Right now (Jan 28, 2PM), the stock is 18.75 and the call is only $1.11  That makes a big difference.  Be that as it may, I'll go ahead and use your numbers as well as the ones that I see right now.

1) If you are adopting this strategy for the purpose 'capturing the dividend,' then it's fairly risky.  The dividend (plus option premium) is small and the potential loss is larger.

2) If you are doing this because you like PFE and want to own its shares, then this plan is viable. You already considered risk when deciding that you want to own the shares.

3) You obviously have an exit point in mind:  A stop-loss on the downside and an assignment (sale at the strike price) on the upside.

What happens when the stock is between those prices?  Do you hold and write another covered call, or do you sell?  There's no dividend for another three months, and you appear to be interested in collecting dividends.  Do you hold despite the fact that the dividend is 'far' away?

4) How do you determine the P/L if uncalled?  What stock price are you using?  I believe you made a mistake.

I find it difficult that you believe you can earn almost 7% if uncalled and only 4% if called.  The stock is higher when you are assigned that exercise notice.

When writing covered calls, being assigned yields the maximum possible profit [Yes, I know if the stock price is a penny or two less than the strike, you save on the assignment fee].

5) To estimate the cost of call repurchase, guess a buy-back date, raise implied volatility (due to price decline) by a small amount, and calculate the option's fair value.

6) With your numbers, if called, you sell @$18, and earn $60 (pay $18.50 sell at $19.10) + dividend.  Less cost of carry (interest you did not earn because cash is tied up in stock).

Using the current  numbers that I see, that's $36 earned + dividend, less cost to carry.  Earnings are almost $54.

The put is $53.  If you sell the Mar18 put instead of buying stock and selling calls, you earn $53. 

That's $1 less.  But you save cost to carry, you save on commissions.  You save on an exercise fee. [If you are going to unload the stock @ 17.22, you can buy the put (to close the trade) and will not incur an assignment fee]  At that point, the put should cost the same as selling stock plus buying the call.

I see no advantage to your buying stock for the dividend. 

I am comparing covered call vs. cash-secured naked put.  I am not telling you to avoid either.  Your investment decision apparently suits your needs, and you cannot bet that.

The two strategies are equivalent and have the same P/L profile.  The dividend is taken into consideration by the option prices.  The evidence for that example comes with using my numbers.  You can double check to see that yours are accurate.  But I caution you to use live bid/ask prices, and never use 'last.'

Don't get your data from Yahoo.

600

Covered calls, naked puts, covered strangles and position size

One important factor in becoming a successful options trader is understanding when you don't know enough to begin trading.  I've said it many times:  Too many rookies buy or sell options with no understanding of how the process works.  That understanding is necessary.  Jason gets that point as this follow-up to a recent post illustrates:

***

Thanks for info. Like your site.  Thanks

I didn't truly think it was a no brainer as I know nothing in the option world is, and that's why I posted.  'Knowing nothing' is a good place to begin. :-)

You mentioned the otm call offers no downside, so if feeling bearish an itm call may work in this situation a well?  Because you asked a question that suggested you had more experience, my reply assumed that.  Had I known this was new to you, I would not have been using ideas that would be brand new to you.

"Work as well?"  It gives you more protection if the stock falls, but it gives you less reward if the stock rises.  So 'works as well' depends on what you are trying to accomplish when writing covered calls.  Some people are very bullish (and sell OTM covered calls) and want to make a lot of money.  For that to happen the stock must rise.  Others are more conservative and are willing to earn ONLY the time premium in the option price.  They write calls that are ITM - for example when the stock is 31 to 32, they buy stock and write a call with a 30 strike price.  NOTE:  Not a 25-strike price.  There is too little profit potential in that.

***Important:  A covered call is a bullish position.  It does well when the market rises and poorly when the market falls.  If 'bearish' this is not an appropriate strategy.  Save it for when you are neutral or slightly bullish.

On the put side. I'm probably over thinking this (NO.  Just not realizing all the ramifications of trading options) but the risk to me is the difference between the put strike minus premium for put sold minus closing stock price correct? If the put triples in value am I responsible for that as well at expiration or only having to purchase stock at the put strike?  Example: Stock is 42 and you sell a put with a strike price of 35 and collect $0.70.  In the stock falls to 35 - the point at which you said you would enter a stop loss order to exit the trade - the put may be trading near $3.00.  If you want to exit the trade, you must buy  back this put.  Yes, you are responsible for the market price of the put.  This is prior to expiration.

At expiration, all the time premium in the option disappears.  But, if the stock drops to 35, it may drop to 30 and the put price would go from $3 to $6 or $7.  Would you hold the put position forever?  That's not how a stop loss works.  If you want to get out of the trade, you must pay the price at which the option is trading NOW.  Just like the person who bought the put from you paid the going price THEN.

If you hold all the way to expiration, then you are correct.  The strike less the premium collected would be the point below which losses accumulate.  But the whole point is that you should not be willing to wait until expiration.  that where knowing when to cut risk comes into play.  That's why you are using a stop loss in the first place (even though it works much better for stock trading than option trading).

Trying to keep a covered position and just squeak out a bit more potential return with least amount of associated risk. Is there another "option" I should consider?  Selling naked puts is an acceptable strategy - as long as you understand what is involved.  In fact, if you plan (for example) to buy 200 shares of stock and write 2 covered calls, trading ONE (not two) of your covered strangle is a reasonable method.  But trading two of them just doubles ultimate risk for very little additional reward.

Look into selling put spreads instead of writing covered calls.  This means a bit of patience on your part.  Do what you are doing; don't take extra risk right now - unless you understand that risk - and try to learn more about options.  You'll love my book, The Rookie's Guide to Options.  But you can find plenty of material on the blog.  Look at credit spreads in categories and read some posts.  Or visit the  CBOE and see what they can tell you about selling put spreads.

Be sure to read the post tomorrow as I added to it before receiving this.  We can continue the conversation later.  I'd love to chat via e-mail, but I simply lack the time to do this because of e-mail volume and other projects.  But do post comments and I will reply to your questions.

Thanks,

Jason 

596

The Covered Strangle. No-Brainer or Risky Trade?

Having just blogged about the fact that equivalent positions are truly equivalent, I received this question that's based on the same topic.

***

Mark,

I have done covered calls for a while. Looking to increase returns without taking on much more risk.

Wondering about a covered spread approach where I own the stock, short OTM calls, short OTM puts, and enter a stop sell order to automatically liquidate shares if stock hits my put strike price to cover situation where stock could be put to me.

This seems like a no brainer to enhance returns without anymore risk but wondering if I've overlooked anything.

Thoughts?

Jason

***

You are referring to a covered strangle. This is another example where it's important to understand equivalent positions.

It is NOT a no-brainer.  This has real risk and obviously a very decent reward potential.

Stop-loss

I agree that the stop-loss order does limit risk, but are you aware of how much risk that is, or are you just assuming it's acceptable?

If you are stopped out of the trade, you can lose a substantial sum on the 'no-brainer' put you sold to enhance profits.   That put is now ATM, making it worth substantially more than the premium you received when selling it.  In addition,  IV has probably increased - and that's also going to hurt.  The passage of time is not going to help enough to offset very much of the loss.

Add to that your covered call position.  I acknowledge that if you were going to exit this trade at the same stop loss point, then you are already aware of how much this trade can lose. 

What concerns me is that you entered the stop loss so that 'the stock could not be put' to you.  That's not a good reason for entering a stop-loss order. [As an aside, I believe that stop-loss orders are very inefficient where options are concerned.  You would be forced to enter a market order when the stock is falling, and that's going to get you a very bad fill because you would be paying the asking price when the bid-ask spread is likely to be extra wide.]

Being assigned an exercise notice

First, no one would exercise a put option that is ATM, so there is no immediate danger of being assigned an exercise notice.  The reason for exiting a trade via stop-loss should NOT be to avoid assignment.  It should be because you decided that the loss at that point is enough.   You recognize the trade has not worked and you want to exit.

Second, when you are writing covered calls, having stock put to you is not so bad.  After all, the covered call and naked put represent a similar trade (in your case with different strike prices).  Having the stock put to you doubles your stock ownership and is merely another covered call position that has gone bad. 

Downside risk

When writing an OTM call, I assume you understand that you have downside risk, and that the call offers very little in downside protection.  If you want to get so aggressive as to sell additional naked puts, I suggest you consider that markets do not always rise, and perhaps writing an ATM, or even an ITM covered call instead of your OTM can provide much-needed protection.  Either provides additional (but limited) downside protection, but the downside is where your risk lies.  That protection is needed when you are about to double your position size (by writing extra puts).

It's important that you recognize that writing an OTM covered call is the same position as selling a naked, ITM put. The loss on that portion of your covered strangle is going to hurt when the stock drops several strike prices and you are stopped out of the trade.  When that happens, don't be surprised when you get a bad fill on buying your OTM call with a market order (higher IV and wider bid/ask spread).

Summary

This is far riskier than you imagine.  You have doubled your position size, going from one naked put to (the equivalent of) two naked puts.  Yes the 2nd is more OTM and not likely to result in your being forced to exit - but 'not likely' events occur all the time.

Rethink this.  If you don't 'see' it then please use some graphing software to plot your positions.  Then you can decide whether the extra risk is worth taking.  It may be a good trade for you.  I want you to be aware of the risks before making the trade.  You should also understand the probability of getting stopped out (that's the delta of the naked put you are selling) of the entire trade.

Be careful.  'No-brainer' options strategies don't exist.

594

Q & A. Hedging the sale of naked puts

Mark,

I follow your blog, having read your "hedge fund" book about a year ago ... which was my introduction to options.  A very understandable book, BTW.  Since then I've used covered calls pretty well ... making a few of the classic mistakes along the way.

Just read your entry about "beating the market".  I am looking at doing a "hedged put-writing strategy", which I've read about in another book (Put Options by Jeffrey Cohen). 

The idea is that you write puts on individual stocks, then hedge by buying OTM puts on one or more of the indexes.  I don't think I've seen you mention that strategy.  Is that an approach that you approve of?

The idea is that you sell the puts on the individual stocks -- stocks that you've done some research on.  He has some guidelines for picking those.  He recommends selling longer term options to generate a decent premium.

And then buying the index puts as the hedge, because the implied volatility is lower on the index, your "insurance" is cheaper.

If all (or a large proportion) of your stock picks happened to decline more than the index, you'd lose.  That seems to be one of the drawbacks.

Brian

***

Hello Brian,

I don't like that specific approach.  In fact, I'd prefer to do just the opposite of what you are suggesting.

In practice, indexes are less volatile than individual stocks (some stocks move up, others down, negating part of the volatility).  Thus, selling naked options or spreads on an index is less likely to result in a loss than selling options on individual stocks.  In return for that reduced volatility, you collect a lower option premium.

By buying puts or calls on individual stocks, you are hoping for a major news announcement and thus a big change in the price of the stock.  I've never tried this, but it's a strategy that has supporters.  Cohen is suggesting you do just the opposite.  This is a personal situation for me, and many investors/traders disagree:  I do not like to try to pick stocks that will out- or under-perform the market.  By doing 'some research' your strategy requires just that.  Thus, it's not for me.  But is it for you?  that's your decision.

Is the purpose of this strategy to sell puts in stocks you are willing to own?  Is it based on the premise that you have the ability to pick winning stocks?  To balance the risk of market movement in the wrong direction (down in your scenario), or of exploding implied volatility on puts you sold, the idea is to buy index options to hedge  those risks.The idea is to prosper by having your stocks outperform the market.I

If that's the rationale behind this strategy - and I don't know what Cohen is thinking here - I don't like it.  First I believe the vast majority of traders are unable to outperform the market.  Yes, day traders play for short-term swings, and many appear to make good money, but investors have longer holding periods.   If you know you can pick winners, from a proven track record, then this method is appealing.  But it's not for the majority.

Second, the margin requirement for these positions is much higher than when you hedge your trade with options on the same underlying.

Third, I don't like the correlation risk.  Sure, you sell puts in stocks you like, but as I mentioned, they are not going higher just because you like them (for most traders).

This method works when your stocks don't collapse.  It doesn't cost when nothing moves and all options expire worthless.  There is one problem if you choose volatile stocks - you may pay too much for your long options.  Obviously this can be balanced by selling the same dollars worth of index options as you pay for your options - but be certain to use a risk graph so you do not oversell index options and incur a loss on a big move.

This is a trading idea for which some practice is required.  You must learn how to determine how far OTM the index options should be and how many to sell.  This sounds right for a short research study - paper trading. 

Correlation Risk

Getting back to the correlation risk mentioned earlier.  I know it's much safer to hedge the specific puts you sell, rather than taking the generic stance of buying index options.  If you sell a bunch of AAPL 180 puts, wouldn't you feel more comfortable owning APPL 175 puts than some NDX puts?  I would.

466

Covered Straddles

This post was included in the Economy and your Finances Carnival- June 21, 2009.

***

A recent comment prompts me to write about a very attractive-looking strategy, the covered straddle.  This method is often chosen by option rookies, believing they have discovered one of the 'best' option trading ideas.

A straddle is a position in which an investor buys or sells both a put and call on the same underlying, with the same strike price and expiration date.

Example:  APPL Straddle
 
Long straddle:  Buy 5 AAPL Jul 140P and 5 Jul 140C

Short straddle: Sell 3 AAPL Oct 135P and 3 Oct 135C

When you sell the straddle and own enough shares to cover the call options (i.e., you own enough stock to deliver, if you are assigned an exercise notice on the calls), then the position is known as a covered straddle.

Thus, an example of a covered straddle:

Buy 500 shares of IBM
Sell 5 Oct 100 calls
Sell 5 Oct 100 puts

What's the appeal of this strategy?  Is this a good strategy for you?

The Appeal

The numbers look great, especially when trading highly volatile, risky stocks.  In fact, many option newbies think of this strategy as a gift (free money).  Isn't not, but let's work through this more slowly.

As of yesterday's close, you could buy SVNT (the stock used by the commenter) at 7.07 and sell the Jun 7.50 straddle @ $3.30. 

If SVNT is above 7.50 when expiration arrives, you are assigned an exercise notice on the calls and sell stock @7.50.  Adding the $3.30 premium, gives you a net selling price of 10.80 - and a net profit of $3.73 per spread, before commissions.  The appeal of that > 50% return is so attractive that too many rookies jump right in, place the trade, and fail to recognize that news must be pending, due to the high option prices.

If the stock remains below 7.50 at expiration, then the investor is assigned an exercise notice on the puts, and buys stock at $7.50 - minus the $3.30 premium.  Net cost: $4.20.

Looks great.  The options are priced this high for a reason.  Most covered straddles do not present such attractive looking numbers.

Is this a good strategy for you?

Probably not.  Here's why: I must remind you that lessons learned earlier still hold true.  One of the important aspects of learning to trade options is understanding that some positions are equivalent to others.

When you own a covered straddle, the position can be broken down into two parts: a covered call plus a naked put.  In case you don't remember, a covered call is a naked put.  Thus, the attractive-looking covered straddle trade is equivalent to the sale of two naked put options.

I've written about naked puts previously, and my recommendation is that this strategy is appropriate for investors who want to accumulate stock positions over time - but that it's too risky for short-term traders who are looking for trading opportunities.  For those investors and traders, I recommend the less-rewarding, but far less risky sale of put spreads, rather than the sale of naked puts.

Thus, this covered straddle is the same as selling two naked puts - and that's fine, if writing naked puts suits your comfort zone and trading style.  Don't make this trade just because the naked puts are disguised as a covered straddle.

346

Q and A. Comparing Spread Risk

Mark:

I thought I would share a sort of activity in which I was engaging for a while (but find no opportunities of late). I have seen related discussions recently in online forums.

The basic idea is that given an equity one finds quite attractive at a price only somewhat below its current price, one can sell naked puts to reach that attractive price goal. [MDW note: Yes, if assigned an exercise notice]

The added twist in which I had been engaged was to risk the same amount of capital in a single strike separation bull put spread [MDW Note:  sell a 45/50 put spread, for example] (or perhaps some other width, depending on the numbers).

A rapid collapse through through the short strike would make me uncomfortable about the possible losses, but allow for the sale of most of the long puts and purchase of all short puts (under those market conditions, providing some profitability to the downside ).

Now the absolute amount at risk has not been reduced, but the rate of loss most certainly has. The goal of acquiring stock at or near the strike price is nearly achieved.

As it happens, I did not have any outsized gains from this activity,nor did I acquire any stock. The consolation prize (outsize gains being the goal) was collected in each case when the market bounced and sudden euphoria set in.

I am now trading ICs in some markets. I am starting to feel uncomfortable about this -- just on an instinctual/gut/superstitious level (yes, I have more on in index ICs).  My concern is all the short vega.

FJ

Thanks for sharing.

There is a fallacy embedded within your idea. Although the stock can fall to zero, it's extremely unlikely.  As a result, the maximum theoretical loss when writing the naked put is almost never realized.

On the other hand, it's much more common for the stock to move through both strikes of a put spread, resulting in (assuming  no adjustments) the maximum theoretical loss. Thus, the reason an 'equivalent amount of capital at risk' is not the correct way to equalize risk.  The probability of incurring that loss must be considered.

If you are considering selling 5 Aug 60 puts @ $3.00, the potential loss can approach $30,000 (Buy 500 shares @60, stock goes to a low price near zero, minus $1,500 premium collected), but in reality, that potential loss is less. There's always time to get out at some price to salvage a portion of your investment.

Compare that play with selling 60 Aug 55/60 put spreads @ $1. The maximum loss for 60 such spreads is $30,000 - less the $6,000 premium collected. Of course, you can use that premium to sell even more spreads, but let's ignore that possibility for this discussion.

Which of these positions is more likely to earn a profit?
Which can earn the higher profit?
Which is more likely to incur a significant loss?

To earn a profit,the stock must not be much lower than 60 when expiration arrives.  For the naked put trade, the break even point is $57, and it's $59 for the put spread sale.  Thus the naked put has a better chance to earn a profit.

But there's $6,000 potential profit when selling the spread compared with one fourth that amount for the naked put sale.  That makes the spread look attractive.

But that attractiveness disappears when you consider potential losses.  If the stock moves to the low 50s at expiration, the naked put seller loses approximately $4,000 less premium, or $2,500.

The put seller loses the maximum, or $5 per spread (less $1 premium).  That's $24,000.

These positions can hardly be considered to have the same risk.  And that's the fallacy in the argument of 'I'll risk the same amount of capital.'

One point I stress in The Rookie's Guide to Options is that the real danger of selling put credit spreads is being unaware of just how much money can be lost.  That encourages many option traders to sell far more spreads than justified.  'Size kills' is an appropriate expression used by investors who understand risk.  You cannot afford to be greedy by taking more risk than your experience and pocketbook can handle.

Regarding the iron condors:  Although short put spreads have risk associated with short vega, it's only half as much as the iron condor.  If negative vega is uncomfortable, consider combining double diagonal spreads with iron condors.  Another reasonable decision is to avoid iron condors and use strategies that are nearer to vega neutral.

Late ADDENDUM: Those profits of which you write that you collect on the downside are a figment of your imagination.  there are no profits.  Only losses.  If you are considering selling all your longs and covering just a few of your short puts, that is a huge gamble.

Please rethink this.

314

Q & A. Margin; Rolling

Dear Mark:

I have been reading several books on options and I have learned a lot, but there are a few questions I have that I still do not completely understand, I hope you are able to help me out!

1) First of all, with writing uncovered puts/calls what are the requirements with major brokerages on this? How much in funds do you need and what do they require of you to be able to trade uncovered?

2) I have been learning about rolling strategies and how if you write an uncovered put if the stock price is currently at 15 and your strike is at 12.5, and if the stock drops to 12.5 or below to avoid exercise you can roll the option. Is there anything else I should know about rolling or can you help be better understand it?

Mike

1) Each broker is allowed to set its own margin requirements, as long as they are not lower that SEC mandates.  The best answer is for you to go to your broker's website.  I know the answer will be there.

Here is a link to Interactive Broker's Margin page.

Selling uncovered calls is considered to be so risky that most brokers will not allow any customer to adopt that strategy.  Others limit it to their most experienced traders.  Selling naked puts is allowed by most, but not all brokers.  Thus, there are no specific requirements.  Your broker will decide.

When selling uncovered options, the margin requirement is

• The cash you collected when selling the option. Plus
• 20% of the stock price. Minus
• The OTM (out of the money) amount.
• Minimum margin $250

Thus, with stock at 80 and the 70 put at 2 (or the 90 call at 2), the margin requirement for selling either option (any month) is:

 $200 + 0.2 * 8000 - 1000 = $800

2) Yes.  There is much you should know. First, rolling is an over used method.  Too many traders believe that if they can roll a position to a lower strike price and a more distant expiration - and if they can collect a cash credit for the trade, that all is well.

It's true that rolling as described gives the trader a decent chance to escape the trade with a profit, and that possibility makes the trade look attractive when it is not.

To me, you should roll the position, ONLY when you like the new position and would consider opening it on its own merits, and not because you happened to roll into it.  For example, if you decided to cover the Mar 12.5 put and roll it into the Sep 10 put for a cash credit of $0.50, that might 'feel' good.  But unless you want to be naked short the Sep 10 put in a stock that has been moving steadily lower, it's much better to simply take your loss on the Mar 12.5 put and find another investment.

Most beginners believe that avoiding a loss is a great idea.  It's not.  You must learn to manage risk - and that means not continuing to hold losing trades with the hope that the stock will turn around and all will be well.  Those small losers can turn into huge losers. 

You are usually better off with a new stock.  After all, it should not matter which stock gives you profits.  What matters is making those profits while keeping risk at reasonable levels.

You must also understand that although calls are seldom exercised prior to expiration (except to collect a dividend), it's not uncommon to be assigned an exercise notice on short put options before expiration.  That happens when the put has moved far into the money.  Hopefully you are not still short that put if the stock drops to 8, but just be aware that it is possible to be assigned - before you roll.  Once assigned, the process cannot be reversed.

209

Recommended Option Strategies: Writing Naked Puts

Selling naked puts is a bullish strategy. But it’s more than an option strategy. In fact it’s best suited for investors who want to accumulate stocks for their portfolios. When selling naked put options, sometimes investors get to buy stock at a good price and at other times those investors settle for a quick profit in the form of a cash consolation prize. It’s a win-win proposition for the right investor.

But you must be aware that large losses are possible when you adopt this strategy, especially in a bear market. If you have no desire to buy stocks, then this is not the best strategy for you. There are other methods for adopting a short-term bullish position for any stock or index.

Safer Alternative

Begin by selling the same put as the naked seller – but also buy a less expensive put option. By purchasing that put, you limit risk. If you are incorrect in your bullish assessment of the stock, the most you can lose is the difference between the strike prices (x 100). Thus, if you sell one put with a 40 strike price and buy one put with a 35 strike price, your maximum loss is the difference ($500), less the cash you collected to place the trade. The naked put seller can lose much more if the stock takes a nosedive.

NOTE: If expiration is near and the put you sold is in the money, it’s decision time.  If you are the trader who is not interested in buying stock, it's best to buy back the put that you sold - to close your position.  You can sell another put spread (expiring in a later month) if you are still bullish on this stock.  But, if you are the investor who accumulates shares at good prices, allow the put owner to exercise.

Thus, selling naked puts is a good method, but only when you are willing (or eager) to add the underlying stock to your portfolio.

Selling naked put options is an excellent strategy – but only if used correctly.  This is not a good play for traders looking for short-term profits.  It allows the purchase of stocks at prices below the current market – and just in case you fail to buy stock (just as investors who submit limit order to buy stock don’t always get their shares) – you get to keep the option premium as your prize for playing the game.  And when you do buy shares, it’s at a favorable price. This strategy deserves more attention by the world’s investors.

Why am I introducing this strategy now, when the market is apparently bearish? It’s part of my ongoing plan for this blog, and that includes discussing each of the six strategies that I recommend (and describe in detail) in The Rookie’s Guide to Options.  Please don’t take this post as a recommendation to sell naked puts at any specific time.

 

The strategy at work

When you sell a put option, two results are possible:

• The option expires worthless (or you repurchase it at a low price). In this scenario you don’t accumulate stock, but you earn the option premium as your profit.

 

• The stock price is below the strike price (40, in the example below) when expiration arrives and you are assigned an exercise notice. (Your broker notifies you that the option owner has exercised his/her rights to sell stock at the strike price. As the option seller, you are obligated to buy the shares.) You now own shares at a price you were willing to pay.

Each of these results should be acceptable to the investor who adopts the strategy of writing (selling) naked puts. You either have a cash profit or you own stock at a good price - or at least it appeared to be a good when when you sold the puts.

Example:

Let’s say you want to buy ZYX at $38.50 per share and the current market price is $41.25. If you sell one ZYX Nov 40 put @ $1.50, you receive $150. If the option expires worthless, that $150 represents your profit. If the stock is below 40 when the November option expires, you are assigned an exercise notice and buy 100 shares @ $40. Because you already collected $1.50 premium, your net cost is $38.50 per share, or your target purchase price. If the stock never traded as low as $38.50, then you own your shares at a great price.

 

NOTE to more experienced traders: This trade is the synthetic equivalent of writing the Nov 40 covered call; i.e. if you buy 100 shares of ZYX @ $41.25 and write one Nov 40 call @ $2.75, your cost is $3,850.  When November expiration comes and goes, you either own stock at $38.50 or earned a $150 profit.

• If the call option expires worthless, you own shares costing $38.50. That’s the same result as selling the Nov 40 put.

• If the stock is above 40 and the call option is exercised, you have no remaining position. Instead you have the same profit ($150) as the naked put seller.
  

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