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.
33
Comments are closed.