Tag Archives | naked puts

Danger: Using one trade to finance another

This is a continuation of an ongoing discussion in the comments section. It all refers back to a post from July 2009.

It began with a comment on this post where Mr X (who manages other pepole’s money) proposed the idea of buying a more useful put (i.e., one with a higher strike price) when constructing a collar. Because that ‘better’ put is more expensive that the traditional put (some small number of strikes out of the money) he included the suggestion of financing that more costly collar by selling a put that is farther OTM than the put owned.

In other words, instead of buying a put that affords 100% protection (after paying the deductible) for the other part of the collar (the long stock/short call portion), he proposed buying a put spread. The idea is to buy an ITM put and sell a put that is 20 to 30% out of the money. He provided statistical data that shows that this was sufficient protection more than 99% of the time. That is reassuring evidence for a trader, but the investor who wants the complete protection of a true collar (think Black Swan), this may not be sufficient protection. It is, however, a reasonable choice for someone to consider.

Quoting Mr X:

So you can actually buy a vertical (buy PUT at the money, sell a PUT 20 to 30% lower). This reduces your protection (can still have a major black swan though), but historically it still protects you against 99% of the market drops. And the cost is cheaper (we are saving 20-30% or so on the cost of the protection).

Bottom line: less costly collar, good enough to work 99% of the time (looking back in time does not mean the same results will occur in the future). As I mentioned: a reasonable alternative. The trade is made for a good reason: It costs less, adds to profits (lower cost = higher profit), and is good enough almost all the time. It’s a very attractive idea – for the more aggressive trader.


The trader has two choices:

  • Own the traditional collar with an (perhaps 5%) OTM put
  • Own a collar with zero deductible (ATM put)
    • This comes with no Black Swan protection

This was my reply at the time:

Overall, I do like the idea of owning the ATM put. But this will not satisfy everyone’s comfort zone. Is it better to avoid the 5% deductible and give up black swan protection? Not an easy decision.

And that was where we left it. An alternative that works better than the collar most of the time, but which leaves the investor facing the possibility of a financial disaster if a true Black Swan event occurs.

That discussion was re-opened recently when a reader commented on the ideas of Mr. X.

One thing led to another and the discussion reached a level where I felt it necessary to post this for other readers.

It is easy to fall into trading traps, and the one discussed by my correspondent is one of those slippery slopes that can lead to blowing up an account. Below is an abbreviated version. The original comment is here

In my mind, this is the progression of a trader:

Step 1: One learns about a put, so they’d like to purchase a put to protect a long position.

[MDW. This trader is off to a very bad start. Learning about puts is not a good reason to buy them. And this really upsets me. One does not BUY or SELL something that is not yet understood. Puts are too expensive for most people to own. It essentially kills any chance to earn profits.

Step 2: To help finance the put, they sell a call, thus they have a collar. They’re willing to part with the stock at the call strike.

MDW: True, it’s a collar. But look what you just did to this poor trader who owned some stock. He ‘learned about’ puts and bought some. Then he sold calls to create a collar. We don’t know that this trader wants to own a collar or even knows what a collar is. This is blind trading for no reason. You are suggesting that this is a ‘step’ in becoming a good trader: Buy a put because the trader learned that they exist (why did he buy and not sell?) and then sell calls just because the trader owns stock and is willing to sell. Two foolish trades. Two steps backwards in an options education. I don’t like being so hard on a loyal reader, but this is not progress.]

Step 3: Like in step 2, they want to help finance the position, so they think of selling a put on the same stock. (this is where you and I agree that this may not be a good idea)

[MDW: I don’t see how this is progress. If the trade is made ONLY to finance the original trade, it is foolish. The discussion you are quoting does not adopt this strategy. Making trades for the sole purpose of raising cash is the (short) path to eventual ruin.]

Step 4: They realize that selling a put on the same stock may not be a good idea because they don’t really want to own it at that strike price.[MDW: Why does the prospect of buying stock at the put strike price occur to you? Not every put seller wants to buy stock. Most traders would cover the put at some future time, rather than take ownership of the shares. There is no indication that the put sale was made for any other purpose than making a trade: Give up the regular collar with its deductible and trade it for a collar with no deductible, but only limited protection. Why is that bad? When I agreed with you originally, I missed the point that Mr X was buying a better put.]

Essentially, they want to sell the put for the wrong reasons and they’re exposed if the stock drops below that lower strike (I think this is where we’re agreeing). [MDW: Not when you explain it this way. In fact, this trader has an excellent reason for selling the put. It lowers costs and leads to profits >99% of the time. What better reason does a trader need, as long as he keeps risk under control by trading the appropriate number of contracts?]

Thus, they try to think of other ways to finance.

[MDW: Why do you believe the trader is seeking other ways to finance? He found a perfectly acceptable method]

Perhaps they could just use existing funds they already have, or they could use the premium from other positions that they would like to own, like by shorting puts on stock B which they are intending to invest in.

[MDW: This trader does not seem to be someone who has any interest in buying any stocks so why would he want to sell puts on stock B? Selling them just to finance another trade is a very poor idea.]

So that’s my thought process of how one gets to this point. The journey doesn’t seem that unreasonable even if individual steps may be ill-advised (i.e. step 3).

[MDW: To me, the journey is dangerous – with each step leading the trader closer to ruin. I do not expect this trader to survive very long]



The big issue for me is that you actively seek ways to ‘finance’ trades. That is a slippery slope that leads to taking far too much risk. If a position is not good enough to own on its own, then it does not belong in the portfolio. It does not have any ‘need’ to be financed.

How does financing the position make it any better to own? Portfolios should be managed by risk and not by how much cash can be collected to finance other positions.

Sure, some trades provide cash that can be used to meet margin requirements of other trades. But making those trades just to generate cash is not smart.

I understand your thinking: If a trader can finance his trades by making other trades that he truly wants as part of the portfolio, that’s a good thing. It keeps the account stocked with cash and eliminates the need to borrow money from the broker.

Look at it from a simplistic point of view. The trader has some positions He seeks to finance them by opening more positions, each of which comes with a net positive cash flow. In other words, the trader sells option premium. Each of those trades involves risk.

It takes a very disciplined trader to recognize when enough premium has been sold. It’s important to prevent over-selling. Once the idea of selling more options to finance other option positions takes hold, it is almost impossible to stop. It will appear to be free money – until the account blows up in one devastating moment.

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The CBOE PUT Index

How many times have you heard it:

Don't sell naked puts.

Ans especially never sell naked puts in a falling market.

The CBOE S&P 500 PutWrite Index follows a portfolio that ONLY sells naked puts.

From the CBOE website:  "The PUT strategy is designed to sell a sequence of one-month, at-the-money, S&P 500 Index puts and invest cash at one- and three-month Treasury Bill rates. The number of puts sold varies from month to month, but is limited so that the amount held in Treasury Bills can finance the maximum possible loss from final settlement of the SPX puts."

In our terminology, these are cash-secured puts, with every penny collected from the sale of the puts being invested in Treasury Bills.

The results are rather interesing, and I've mentioned this topic previously.


Jason Ungar at Gresham Investment Management, one of the developers of PUT, publishes a monthly update on the perfromance of 'his' index. You may request a copy via the link. He is very pleased at how well his 'baby' performs.


A recent blog post by Don Fishback, 12/07/2010, puts its performance into perspective:

CBOE PUT Index at a New All-Time High

"Wow, did I miss this!  The CBOE’s PUT Index hit a new all-time high on November 4, eclipsing the peak in May 2008.  It has since extended that rally even further.

Who says selling puts is more risky than buying stocks?!

It’s not the put that’s the problem.  It’s the excessive leverage some people use, and not knowing what to do in the unlikely event that something goes wrong that gets put sellers in trouble.

I’ve got no problem with leverage.  It’s just that there can be too much of a good thing.  And you have to have an exit strategy BEFORE you put the trade on."


Don offers the classic and correct warnings: Don't use too much leverage (that means do not sell ten 20-delta puts as a hedge against being short 200 shares of stock). Have an exit strategy planned in advance. Another piece of advice that emphasizes the importance of writing a trade plan.  Don't be stubborn.  It's impossible to win every month when following this strategy.  However, you can be a winner by exercising good judgment when managing risk.

Followers of PUT have no such concerns.  The methodology is written in stone.  Sell the puts and don't do anything prior to expiration.  Those results have been impressive over the years. However, you and I e not managers of an Index fund.  We use our own cash and must pay attention to risk.

As individual traders, we are not married to a single technique.  We can, and should, manage risk.  By keeping risk in line, we may underperform the CBOE S&P 500 PUT index, but we will never incur a humongous loss.  And that's far more important.

And the evidence tells us that selling naked puts isn't so bad after all – to be more specific it has not been so bad for the lifetime of the PUT index.  And that lifeteime began in mid 2007.  It's a very short lifetime, but it did include the massive declines of 2008-2009 and has not only survived, but is trading at new highs.  Nice index.  Thanks JU.

Addendum from Jason Unger: " Just one thing, the CBOE has backtested the PUT to July 1986; and even including the 1987 crash, it outperforms the S&P 500 in just about every metric."




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More on the equivalency of covered calls and naked puts

A regular commenter, semuren, recently offered a comment that made an important contribution to a discussion:

"while what you say about naked puts being equivalent to covered calls is correct, there is a big issue here. In general people trade naked puts differently than they trade covered calls. Most sell a slightly OTM call for a covered call or an OTM put as a naked put.

Those are not equivalent and that is why people view these two strategies as different. In the end it is all about practice, how people actually do things, not about ultimately correct notions. But I do not want to go off on a discussion of epistemology in the social sciences so I will just leave it at that for now."


I have often stated, and sometimes offered proof, that the two option strategies: writing covered calls and selling cash-secured, naked puts are equivalent.

When positions are equivalent, the profit/loss profiles are identical.  In the real world, the pricing of options may allow one strategy to offer a slightly higher profit than the other, but that can be ignored for a theoretical discussion.

The one qualification that I mention is that the covered call and put must have three characteristics in common:

  • Same underlying asset
  • Same expiration date
  • Same strike price

For example, when the stock price is 38, that means that writing the Nov 40 covered call provides the same result as selling the Nov 40 put.

That statement remains true.  But in a practical sense it's not helpful to the majority of  individual investors/traders.  If it's true, why is it not always helpful?

As semuren mentions, most people who adopt these strategy are oblivious to the concept of equivalent positions, and tend to sell options that are out of the money.  There is a good psychological reason for doing so.

Traders, especially inexperienced traders, get a certain satisfaction out of seeing the options they sold expire worthless. Such results are 'pleasing' because a trade was made and completed profitably. To many traders, that's all that matters. It gives the trader a psychological boost.

The fact that the trader may have lost money on the overall position (example, sell a covered call, collect $200 in premium, and lose $500 when the stock price declines) is ignored.  The satisfaction comes from earning money on the call sale.

The experienced trader does not look at writing covered calls as two separate trades. It's a single position and the trader manages the position and its risk accordingly. This trader  understands that a loss has been taken and that there is no psychological boost in that.

Nevertheless, Options for Rookies is designed to guide beginnes towards making good investing/trading decsions, and the equivalency of covered calls and selling cash secured puts is important.

Expiring worthless

Because of this preference to make a trade in which the option expires worthless, both trades are most often made by writing OTM options.

Thus, the covered call writer sells the Nov 40 call and the put seller writes the Nov 35 put.

Those positons are not equivalent.  Although the equivalency issues is very important in understanding how options work, in this example, it's not really an importance trading principle to the rookie trader. 

That's because that rookie seldom considers selling the Nov 40 put.  In this trader's real world, the trade choices are the Nov 40 covered call and the Nov 35 put sale.

Again, it's crucial to an options education to understand equivalence.   However, there are times when theory gets in the way and may confuse a new trader.


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Covered Calls and Naked Puts Revisited

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When a rookie trader first becomes aware that some positions produce identical profits and losses, regardless of the price of the underlying asset, it's truly an 'aha' moment. 

It's as if a veil has been lifted and the world has become a brighter place.

  Because I believe this is an important concept and truly enhances a rookie's ability to understand options far more quickly, I devoted a chapter to the concept of equivalent positions in The Rookie's Guide to Options.  I also  provided a solid introduction to the topic in some earlier posts.

Because the primary purpose of this blog is to provide an education to option rookies, let's take a closer look at two different strategies: covered call writing and naked put selling.

But first a word of caution:  These two strategies are most beneficial to investors whose only investment experience consists of owning a portfolio of stocks, mutual funds, or exchange traded funds (ETFs).  Each of these strategies is a less risky method for investing in the stock market – when compared with owning stocks.  The investor earns a profit more frequently, loses less often and does well when the market rallies, trades in a narrow range, or even when it undergoes a small decline.  In each of those scenarios the covered call writer and naked put seller outperform their counterparts who simply own stock.

However, these are considered to be 'not-so-safe' strategies.  If the market tumbles, losses can be sizable.  In that respect, losses are similar to (but smaller than) losses incurred by thsoe who own stock.  And upside profits are limited, whereas the investor who owns stock has the potential for unlimited gains.

Nevertheless, these are both very popular strategies because they are safer than owning stock and offer an investing style that is easy to learn.  I use these strategies to introduce rookies to the world of options.  Once these methods are well understood, then I move on to less risky plays.


If the simple algebra used in the proof that these methods are equivalent was not enough proof, let's take a look at the profit/loss graph for a pair of equivalent positions.  Although this is not strictly 'proof' I hope that seeing identical graphs goes a long way towards convincing you that these positions truly are equivalent.

Previous posts offered more details about covered call writing and naked put writing ('write' has the same meaning as 'sell' – when the investor is not selling an option that was bought earlier).

To be equivalent, the option part (the call or put option that is written, or sold) of each trade must have these elements in common:

  • The same underlying asset
  • The same strike price
  • The same expiration date

Risk Graphs

APPL Jan 300 covered call


AAPL Jan 300 naked put

These graphs are essentially identical.  Any minor difference occurs because the price of the trade execution always plays a role.  Our discussion is based on the assumption that neither trade is made at an advantageous price over the other.  

Interest rates are very low, but it does cost more to carry the covered call position (cash required to buy the position) than the naked put (cash collected when selling the put) and thus the CC should appear to be slightly more profitable by the cost of owning the position through expiration.

One myth that can be destroyed here is that a naked put is riskier than a covered call.  The positions are equivalent.


Other positions

These are not the only two option positions that are equivalent.  Keep in mind that calls are puts and puts are calls (all a trader has to do to convert one to the other is add stock – long or short – to any position).


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Picking the Right Hedge


I think
what I might not fully understand on Risk Management is exactly what
type of hedge is needed. For example: On my Cash secured puts..what is a
good hedge, is it buying long puts and when? When the market starts in
the other direction or when first selling the puts?  What type of hedge with
what type of trade?



You enter into a trade with the expectation of being able to earn a profit.  If all goes well, you exit the trade and collect the profit.

When the trade is not working, you have choices.  The first is to stubbornly hold that trade.  In my opinion this is foolish, unless you (be honest with yourself) truly want to own the trade with its current risk and reward potential.

The next obvious choice is to acknowledge that this specific position is not working and that you no longer have any confidence that it will work. Exit the trade.  There is no reason to hedge or adjust a position that no longer meets your needs.

The most popular choice among option traders is to hedge (reduce the risk of holding) the trade.  Your question deals with knowing what to do when making this adjustment to your position.  Before replying, I must mention that attempting to salvage a bad position – with the hope of recovering losses – is an over-utilized strategy.  

The only time (this is my opinion, not a law) to adjust a position is when you can modify it so that it meets your qualifications for a new trade.  In other words, ignoring any loss incurred so far, the position – after it is adjusted – must be 'good,' i.e., you want to own it.  Remember it's quick and easy to exit, so if you make the adjustment it should be because you like the prospects of the altered position.

Far too many traders 'fix' the current problem, hoping to recover losses – and not because the fixed position is worth holding.  This is a trap.  Do not fall into it.  You already incurred the loss, so your job as an intelligent trader, is to find the best way to invest your money going forward.

Let's assume you elect to hedge the position.

There is no 'best' answer to the dilemma: Which hedge to choose?

Your position is naked short puts.

1) Size the trade. The maximum possible loss must be acceptable – not be a happy event, but one you accept.  Thus, the first hedge occurs at the time of the trade: don't sell too many puts.

2) Yes, buying other puts is the easiest and safest method for reducing risk. It's my first choice, but that does not mean it's your first choice.  It costs cash to buy puts and not every trader is willing to make that trade.  It severely cuts profit potential, but it also establishes a maximum loss.

But does it give you the position you want to own?  There was a reason you chose to sell naked puts, rather than put spreads.  That suggests that this is not the right hedge for you.  If it is, you must understand why you prefer to sell naked puts as the initial trade.

3) If you elect to buy puts for protection, when is a good time?  There are many reasonable times. 

You can buy when you enter the trade.  That means selling a put spread instead of just selling puts.  That's a different risk/reward profile – and no one can tell you which trade is better suited for you, your investment style, your investment goals, and your tolerance for risk. That is for you to decide.  No one can help with this decision.  If your goal is to aggressively seek profits, then put spreads may be too conservative.  If your goal is profit with reasonable risk, then put spreads should be more appealing.

You can hedge when the market rallies and the put becomes cheaper, but most people avoid that, believing the hedge is no longer necessary.

You can buy puts on a decline, when the position becomes more risky to hold. It's more expensive to buy puts in this situation, but to compensate, there will be many instances in which you never have to hedge.

There is no correct answer.  There is no best way to handle this decision.  There is only your trade plan.  How much risk are you willing to take?  How much reward do you need to take that risk?  When do you acknowledge that the original plan is not working?

4) What type of hedge with what type of trade?  This is a topic that I'll be covering to some degree in the series on risk management, but you must know there is no universally accepted correct answer.

Donald, I think you are looking for simple answers to complex questions.  They do not exist.  For example, some traders prefer to hedge a short put (your trade) by selling a naked call.  I would never do that (although I did it many times, many years ago).  It's too risky for me.  But how can I know if it's too risky for you?

If you decide to buy puts, how will you choose the strike price or the expiration date, or the quantity to buy?  There are many ways to attack this problem.  My suggestion is to consider several alternatives, examine the risk graph for each and find a scenario that leaves you with acceptable risk and sufficient reward.

This may seem to be a big time waster, but it's not.  Eventually you will find a style of put buying that works for you.  There are so many reasonable choices that you must (ok, should)  practice (paper trading account?) to see which type of trade leaves you in a comfortable position. 

Some traders prefer to do nothing until the trade reaches a point where prudent risk management dictates exiting and taking the loss.

Some traders use shares of the underlying stock to occasionally move the trade back to delta neutral.  This is a very popular method.  I don't use it, but that doesn't mean you shouldn't.

You have to find your own answers.  I hope this reply has given you enough to begin the search.


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