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Jan 8 2011 / Stocks - MSFT, KFT, NUE
Strategies Mentioned : Married Put, Naked Put. Spread, Collar

Question About Spreads Versus Selling Put Options

Strategy Article

Today I received a question from a reader which I thought might interest other readers:

Question: Do you ever buy put far OTM as protection against your cash-secured naked puts? For example, if you sold 5 CSP OTM on a $20 stock you would need $10,000 to cover if assigned on all, but your requirement would be reduced if you bought a OTM put on a long expiration time (like >1 year). Wouldn't this reduce your risk on a catostrophic event, still allow you to get the stock at reduced price if assigned, and continue to sell puts each month if expires worthless? for example,  buying the put for one months of income to gain downside protection on catastrophic event. Just curious on your thoughts. BTW, love your trading plan and thanks for all your hard work.

My Answer: Thanks for your question. The strategy you are mentioning is a spread or could also be considered a collar. Those strategies have merit. However one of the problems with them is that there is still going to be a loss if the stock collapses. While the loss is minimized through the spread, I am paying for the protection through having to buy a naked put for the protection. This cuts into my premium earned. You can view a Microsoft - Married Put trade here and a Nucor Married Put trade here.
It is important to realize that I am not selling naked puts just for income. While many investors sell naked puts for income only and never want to own the shares, I am selling naked puts on stocks I want to own. However I want to use other people’s money to pay for those shares when I eventually take assignment. If you look at the Kraft trade you can see what I mean. With the Kraft trade I made enough from rolling the naked puts to own 500 shares with other people’s money.
So the stocks I am presently trading I want to someday own. That is the key distinction. Therefore I am not interested in owning puts to protect against a decline. Instead I prefer to stay in the stock during a decline and continue to roll down and out further in time in order to continue to garner more income. Look at my MSFT trade . I sold naked puts throughout 2009 and 2010 as the stock climbed. Then I got caught holding the $29 and $26 strike naked puts when the stock pulled back. I then rolled my $29 and $26 naked puts further out in time and slowly reduced the number of contracts with each roll. With each put contract that I reduce I then take that freed up capital to sell a further out of the money naked put on the same stock. Basically I am using naked puts to average down on the stock. As long as I stay ahead of the expiring month and roll early I have been able to stay in naked puts for years while a stock slowly works its way back up.

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