In this second part of my article about Naked Puts on McDonalds Stock I will look at a number of naked puts strategies that an investor could use to avoid being assigned shares. It is important to realize from the outset that buying to close the naked puts while it will incur losses, is the simplest and easiest way to end this trade and stop any further losses from occurring. While this would not be my choice for this naked puts trade, it is still a very practical strategy. The loss taken on buying back the naked puts for McDonalds Stock can possibly be recovered through other trades should they prove more profitable. That though is the question. Can the investor take this losing naked puts position and make the loss back quickly with another position. Often investors buy back their naked puts only to find that the next trade they enter just adds to the already realized losses. It is because of this reason that I changed to selling naked puts against stocks I would love to own since they afford me a lot more opportunity for a wider variety of recovery strategies.
Naked Puts On McDonalds Stock
From Part 1 of this article you can understand how mistakes can be made when selling puts and how to learn from those mistakes to become a better investor. Consistent returns are the only way to compound your capital. Continual losses make growing your capital difficult as your capital must always be working harder with every trade, as losses have to be recovered and then profit built.
With the investor holding McDonalds Stock $95 strike naked puts, and now deciding not to accept shares, what strategies could this investor contemplate to rescue his naked puts loss. Here are 6 of the simplest strategies that could be used. Only 1 strategy will see a loss while the other 5 will see a profit maintained throughout the trade.
Naked Puts Strategy Number 1 – Buy To Close – A Loss Will Be Incurred
The easiest strategy would be to buy to close the naked puts and take the loss. It is simple, swift and over. For those investors who do not want to accept shares ever, they need to establish a criteria by which they will always close losing positions and move on to reduce the size of losses. For many that criteria is a loss of no more than 25%. Therefore if our investor used that criteria he would have sold the puts for $2.07 and multiplied this amount by 25%. This gives the investor a target price of $2.59. If the May $95 put option reached a buy to close price of $2.59, the naked put investor would buy to close and take the loss. It is discipline that makes a successful trader, but it is also discipline that makes a trader smarter with each losing trade.
The investor who loses 25% on his put selling trade should look at the trade to determine what went wrong and discover how he could have avoided this loss. By doing this he would see that McDonalds stock was already in a major decline when he sold the naked puts and obviously he should not have sold the $95 strike. Some investors will learn from that mistake and not repeat it. Many investors will not learn and will repeat the mistake. This is one of the major reasons so many investors quit naked put selling as a strategy since they fail to examine what went wrong with their naked put trade and how to correct it for the next trade.
Making The Naked Puts Strategy #1 Decision:
To decide whether to do strategy number 1 the investor should consider if he can easily recover this loss on another stock. At the time of writing this article (May 14 2012) the cost to close the $95 naked put is $4.20. The loss would be $639.00 after deducting the $621.00 earned from the original sell of the naked puts. Can this be recovered in one trade? As well if the investor feels he just wants out, then nothing can beat the straight buy to close, take the loss on the naked puts and leave the stock.
Naked Puts Strategy Number 2 – Roll The Naked Put Option Forward
This is probably the second easiest strategy for the McDonalds Stock $95 naked put strike. The key to this strategy is for the investor to decide whether he feels the stock is just in a slump and will recover or at the worst, not fall further. Remember that the stock does not need to recover to $95 to turn this trade into a profit. Simply rolling forward will earn income and if the stock does not fall further, the investor will recover his loss in two or three rolls. He can then buy to close his naked puts and move on to another stock.
The chart below shows the 1 year chart for McDonalds Stock. While the $95 strike shows limited support for the stock despite its rise this past spring, there does appear to be reasonably solid support at $90.00 which stretches back to July of 2011. In the summer of 2011 McDonalds Stock faced stiff resistance at the $90 strike but once that level broke it became support for the stock.
If the investor rolls his naked puts forward one month at a time, and McDonalds stock does not fall below $90.00, each roll should earn about $1.00 of additional premium. For example, the cost to buy to close the May $95 naked puts was $4.20 today. The premium earned to sell the June $95 puts is $5.10 or .90 cents. This means the investor has earned $2.07 plus .90 for a total of $2.97. His cost is now reduced in the stock to $92.03. Two more rolls and he will break even on the trade as long as the stock does not fall below $90.00. At the same time if the stock climbs he can buy to close earlier and leave the position for another stock.
For those put sellers who are a bit longer-term in their outlook, there is also the possibility of rolling into September. The September $95 naked puts can be sold for $6.90 which would give the investor earnings of $2.07 plus $2.70 (6.90 – 4.20) for a total of $4.77. Now he is protected to $90.23. ($95 naked put sold less $4.77 = $90.23). If the stock moves between $90.00 and $92.00 by the middle of July, the September put will lose enough value to allow the put seller to buy to close his naked puts earlier than September without a loss and be done with the trade.
Making The Naked Puts Strategy #2 Decision:
Rolling the naked put option forward at the same put strike is an excellent strategy if the investor thinks that the stock will recover or not fall further than $90.00 and eventually through rolling one month at a time, he should reach a point of break-even within a few months and can close his naked puts without being assigned shares. This strategy is simple to implement and requires minimum watching.
Naked Put Strategy Number 3 – Roll the Naked Put Option Forward And Reduce The Number Of Contracts
This is a favorite strategy of mine for a number of reasons. However it works best for those investors who would not mind eventually owning shares. For example, to buy to close the May $95 McDonalds Stock Naked Puts strike will cost $4.20. The investor is holding 3 naked puts. Cost to buy to close = $1260.00. Divide that amount by 2 put contracts = $6.30 per contract. In order to cover my cost to buy to close these three naked put contracts and sell just 2 other put contracts, I need $6.30 of put premium.
The September $95 strike offers $6.85. If I sell just 2 naked put contracts at $95.00 for $6.85 my total earnings are $1370.00. I have now reduced my exposure in McDonalds Stock by 100 shares or $9500.00.
A twist can be added to this strategy by taking the balance of $9500.00 and using it to sell naked puts at lower strikes to earn more income and reduce my average entry price on McDonalds. For example:
Buy 3 May $95 Naked Puts at $4.20 each = ($1260.00) cost.
Sell 2 Sept $95 Naked Puts at $6.85 each = $1370.00 income
Sell 1 Sept $80 Naked Put at $1.12 = $112.00 income.
If assigned on all three naked puts positions, cost will be = 200 X $95.00 = $19000.00 plus 100 X $80 = $8000.00 /300 shares = $90.00 average price.
Also consider the income earned to date = $2.07 X 300 = $621.00 plus roll of 2 naked puts into September $95 = $110.00 plus $112.00 from the September $80 naked put. Total income earned = $843.00. Average share price cost basis in McDonalds Stock is reduced to $87.19.
At $87.19 this puts the investor into the stock at prices last seen in the spring of 2011.
McDonalds Stock Chart
Looking at the McDonalds Stock 12 month Chart below you can see the distinct advantage this strategy has of reducing the naked puts contracts with each roll. While the $95 strike is higher than many investors may be comfortable with, future rolls could see the investor roll down to $92.50. Meanwhile the Naked put at the $80 strike is a level not seen in over a year and is probably a safe bet which could be repeated every 4 months.
If assigned on all shares the cost basis of $87.19 places the investor perfectly in the middle of last summer valuations which should make selling covered calls an excellent strategy to add to this naked put strategy.
Consider The Power Of McDonalds Stock Dividend
The present annual dividend of $2.80 works out to 3.2% yield with the stock at $87.19. 10 years ago McDonalds stock was paying an annual dividend of .235 cents. Today that annual dividend is $2.80. Even if McDonalds If history is any guide, in 2008 the quarterly dividend was .375 and today it is almost double that amount. If over the next 10 years McDonalds Stock doubled its dividend it would be paying over $5.00 annually.
Making The Naked Puts Strategy #3 Decision:
To make this naked puts strategy decision an investor should be willing to accept shares at some point. An investor must have confidence that the stock is going to fall no further than 87.50 over the next 4 months for this trade to work in his favor.
Meanwhile though the investor can continue the rolling strategy almost indefinitely and should the dividend continue to climb I would think the likelihood of McDonalds stock falling back to the mid $50’s is probably unlikely over the next year which should afford the investor the chance to roll naked puts forward and down perhaps a couple of times over the next year and a half. This would be a profitable trade.
The final three naked puts strategies are found on part 3 of this article.
Investor Relations For McDonalds Stock
Naked Puts Option Chain On MCD Stock