Option Trading College
 

Subject: Naked Puts
Instructor: The donFranko
Length: 4 sessions

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Entry is Key...Exit is Everything! ^TM

Session 1 – Naked Puts   

How would you like to collect some rent without spending any money?

Savvy option investors have been doing this type of strategy for decades; however, it's not for everyone. When you sell options, you have a 2 in 3 chance of making money. The reason for this is because you have two powerful things working for you instead of against you: Time decay (Theta) and the premium you take in which is determined by the implied volatility (Vega) of that option contract.

The terms used for this strategy are: Naked Put, Uncovered Put, Naked Put Writing

When you sell a naked put, you are doing so with the anticipation the stock will move higher allowing you to capture the premium offered without having to purchase any stock. The premium you take in is yours to keep so long as the stock closes above your strike price sold on expiration day. If the stock closes below your strike price sold, then you MUST purchase the stock at the strike price you sold if you have not closed out (bought back) your option. However, if the stock falls below your sold strike any time before expiration day, the stock could be "put" to you . This is why it's considered one of the riskiest strategies in option trading for new or novice investors.

Not everyone can do this strategy because Brokers require a large account, typically $100k (some may do it with $50k) in value to do this strategy because of the high risk of failure. Because of this, Brokers must be assured you have enough liquidity to buy all the shares of the stock in the event of a melt-down. This is why you NEVER sell a lot of contracts on naked puts, especially if the stock is a volatile stock or there are news events coming up such as: earnings announcements, FDA announcements, FOMC announcements etc. The best way to do this strategy is to only do it on slow moving stocks, and only on stocks you definitely would prefer to own—Many investors like to sell naked puts first on stocks they want to own. That way , they get paid to buy their stocks if it's put to them.

There must be limits on how many contracts you sell naked. You are allowed 4:1 leverage during the day on your account; however, you NEVER sell naked at 4:1...in fact I do not recommend you even sell at 2:1 because your Broker will require you to put up 30% of the underlying stock value (usually in cash) plus they hold onto the premium you took in while you have the naked put option open. This amount can fluctuate with the movement of the stock, so it can cut into your day-to-day buying power for other trading activities. This is why I personally would NEVER sell enough naked put contracts that would require me to use up more than 50% of my actual account cash value.

Rules to live by:

• NEVER sell naked on stocks you do not want to own.

• NEVER sell naked on volatile stocks that have a track record of dropping heavily in price due to market news, company news or earnings etc. unless you absolutely want to own them.

• NEVER sell enough naked contracts that would require you to use up more than 30% – 50% of your account value if the stock were to get put to you.

• NEVER get greedy when you are winning and the stock is barely above your sold price at or near expiration day. Just purchase back your naked puts and give back some of your profits rather than risk a dip below your strike sold and then be forced to purchase the stock.

• NEVER sell naked puts out of the money because you will no doubt have it put to you on any dip the stock takes.

• NEVER sell naked puts on stocks that have just been downgraded by a major brokerage analyst.

• NEVER go against a trend, negative news or upcoming earnings announcements.

• NEVER guess!

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Session 2 – Example of a Naked Put   

Here is how you should work this strategy.

First off, always look at stocks you would be willing to own if they were put to you. Next you look for that stock to bounce off a known support level and start to move higher (see Charting 101). I prefer to go with stocks that are moving higher on the Daily, Weekly and Monthly charts combined. I also like to stack the odds in my favor, so I always check for things like: recent news that is positive; the stock has received a recent buy upgrade from a major brokerage analyst and it has a lot of open interest on the put side if it was; that way, if the stock continues to move higher, all of those put buyers will be forced to sell at a loss and the short sellers will have to cover.  Do your due diligence to stack the odds in your favor if you plan on trading with this strategy and are trying to capture premium and not necessarily trying to get the stock put to you.

The best time to put on this strategy is the first week of the new options cycle; I also prefer to NOT do this heading into a weekend because a lot of the news and upgrade/downgrade recommendations start over the weekend and get released on  Mondays.

For this example I am going to choose RIMM as my risky volatile stock.

At the time of this writing (8/7/09), (RIMM) is trading at approximately $77.09 per share and appears to be in an uptrend on the daily, holding support on the weekly and showing a potential breakout pattern (strength) on the monthly; however, I would definitely have preferred doing this back in July on the daily chart, but for now it will do as our example. When I find a better looking trade I will post it here for comparison. Maybe this will actually be a better lesson for you if the stock goes the wrong way from this point ;-).

In order to do this strategy, you have to do a minimum of one contract (100 shares) and you will be required to put up 30% of the underlying stock value plus the premium taken in to put on this trade.

Looking at today's options we have the following call premium opportunities:

The best choice at this time for me would be the Aug 70's. The reason is because we only have two weeks to expiration and RIMM could easily take a dip; and support on the weekly chart is just above $70. If you do not care about getting this stock put to you, then the 75's pay some nice premium ($1.39 per share) for two more weeks. You always have to consider your trade objective and risk/reward potential. This is why it's imperative you NEVER sell Naked Puts on stocks you do not want to own.

Note: whenever you sell a naked put, you always get the premium at the "Bid". Also, you will pay a commission for the trade, so you really need to be able to collect enough premium to cover trading costs and make it worth your risk. I prefer to do a minimum of 5 contracts.

For example:

500 shares of RIMM at the $75 strike price would would require me to spend $37,500 if the stock were put to me. I would receive $695 in premium (minus the cost of the trade) if the options expire worthless. In order to put on this trade, I have to put up 30% of the cost of the shares which would be a minimum of $11,250 in cash; and the premium collected is held by the broker until expiration or when I close the trade out. As the stock fluctuates in value my cash requirements also adjust so you you have to make sure you do not sell to many puts as this will reduce your daily buying power for other trading strategies.

Here is what happened on Expiration day 8/21/09:

RIMM barely closed over our naked put strike price, but notice it dipped below $75 for almost a week. This could have been put to us but most likely you were safe due to the premium you would have taken in on the 75's. Still, it would have been a bit of a gut checker if you did NOT want to get the stock put to you.

Session 3 – Concerns  

What's the downside?

All stock investing carries risk. The main risk is a potential 100% loss of your capital invested. Options are no different, yet worse, or actually better in some ways. When you buy call options, you have a limited time to act on that option contract in order to make a profit or suffer a loss. In order to make that profit, the stock has to move higher in value than the strike price you bought (plus the premium you paid) in order for you to make a profit.  If it does not make it there by expiration, then 100% of the money you spent will be lost unless you sell the call options for a smaller loss before the prices are reduced to zero.—This also applies in the same manner to regular put options in that you are betting the stock will go lower in order to make your profit.

Note: only the amount you invested in the options contract is at risk; giving you less exposure than buying the stock outright and it drops in value more than the money you invested in the options.— I have seen many stocks get whacked better than 25% in a single day!

If you just purchased the stock outright, you have no time decay to be concerned with other than the life of the company. But do not let that false sense of security lull you into that way of  thinking. Maybe you have heard of a few of these huge companies in the past few years that are no longer with us: Enron, MCI/Worldcom, Sears, K-Mart, Bear Sterns to name a few. some of these stocks  deteriorated slowly giving investors time to adjust, but some were cut to nothing in a short period of time leaving a lot of uneducated investors looking at headlights. Also, any stock could get its share price devastated on bad news, poor earnings, scandal, cooking the books etc. and be reduced to a pittance of the value you paid for it. Ah yes, and the sky is falling too.

Seriously, the stock market has risks, but you can learn how to mitigate the downside with insurance policies...aka...puts. Sadly, so many investors have no clue how to do this and neither do a lot of Stock Brokers as well.

Ok, so if you sell a "naked" put, what is the downside? Answer: getting the stock put to you. This is why you NEVER sell naked puts on stocks you are not 100% prepared to own...period!

If the stock does get put to you, do not worry, because you have more options you can use to mitigate that circumstance.

Session 4 – Tweaks On Naked Puts   

Here are a couple of tweaks you can do with naked puts

If you did your due diligence, picked your entry correctly and then sold your naked put only to have the stock start to sell off and put you at risk of having to buy the shares, what can you do if you decide you really do not want to buy them?

First off, always remember that once you sell a naked put you are obligated to buy the stock and it can be put to you at anytime once the trade is initiated. Now this does not happen most of the time, but there are certainly instances where and when it can happen. If the stock takes a sudden sharp dip or decline, then you can expect a call or email from your broker telling you the stock has been purchased. This is why I emphasize you must be ready at all times to own the stock you are trading; and if you are doing more volatile stocks; you must be able to watch the market every day you have the position open.— NEVER SELL MORE NAKED PUTS THAN YOU HAVE THE CASH TO BUY THE SHARES WITHOUT USING ANY MARGIN!

Once you have the position open, the price of the puts will fluctuate based on the price movement of the stock. The ideal situation is the stock rises from the second you are filled and stays above your sold strike price through expiration....cha ching!

But, what if it's running very close to your sold strike price? There is a grey area in the market in that you took in premium right? Well that premium acts as a buffer (not always) to offset the close ratio of price discrepancies in the stock vs. the strike you sold; so long as there is premium left in the puts (meaning the stock price is below your strike sold); you have the risk of having some or all of the shares of that stock put to you; however, you can decrease the odds of this by doing the following tweak.

Buy back the puts and then sell the next month out.

This gives you much higher odds that the stock will not be put to you in the event it's trading below your strike price on expiration day. Notice I said "higher odds" because no matter how far in the future you sell a naked put, you can still get some or all of the shares put to you. The saving grace is how many contracts, shares and float the company has that will determine your ultimate risk. The more open interest in put/call contracts and the larger the share float, along with more time, is the best hedge of having some or all of the stock put to you.

What if my puts actually go up in value because the stock is falling too fast? This is why you must do your homework and pick your entries carefully. You are attempting to collect premium with this strategy and not gamble!

If the stock is dropping, then your puts will increase in value; however, you do not benefit because once you sell your naked put, you have collected the maximum premium offered at that time. If the stock is falling fast, then you have two choices: buy back the puts at a higher price by giving back your premium and paying the higher cost for the put contract—From there you either call it a trade and look for the next one—or if you believe this was just a hiccup in the price movement, you can simply sell the next month out. By doing this, you will take in more premium that typically covers all your loss and still gives you a profit once the stock moves back up over your strike price sold.—you can keep doing this until the play works out or the stock gets put to you.

Here is an example: