Naked puts is a strategy that a lot of investors enjoy until the stock they are selling pulls back and leaves them with in the money puts that cost a lot more to buy to close than was taken in at the time of selling the naked puts. Once an investor has a few such instances he begins to doubt the use of selling naked puts as a strategy for profit and income. Soon he is telling everyone what a huge mistake options are and how risky they can be.
I believe this is because most investors just want to earn the put premium without doing any research in advance to understand the risk versus the reward scenario they are entering into. Investors need to develop strategies that assist them when their naked puts positions moves the wrong way. Many investors approach selling naked puts as no different then just buying a stock and hoping it all works out. Investing is work. Learning how to apply strategies whether stocks or options is the only way to consistently become profitable. In a bull market naked puts work well but in a bear or correction a lot of investors quickly learn to hate selling naked puts.
This is the third and final part of my look at Naked Puts On McDonalds Stock that have fallen in the money and strategies to consider once they have fallen. Just to refresh readers, this article is a result of a forum member who sold the May (2012) $95 naked put strike on McDonalds Stock for $2.07 and once the stock fell below $93.00 decided he did not want to own the stock but wanted to see what strategies could be used to try to turn what will be a loss if he buys back the sold naked puts, into a profit or at least a break-even situation.
The first three strategies presented in Part 2 were simpler strategies than my final 3 strategies and 2 variations in Part 3. But even the strategies below are simple enough that any investor could apply them to a variety of stocks, not just McDonalds Stock.
Naked Put Strategy Number 4 – Roll the Naked Put Option Forward and Down
This is a straight forward approach to naked puts that have gone in the money. The investor buys back the May $95 put option for $4.20 and rolls out to a lower strike either for the same amount or a small net debit or net credit.
For example the September $92.50 can be sold for $5.25 which would move the investor’s put strike down to $92.50, and provide a net credit on the roll down of $1.05. Combined with the $2.07 already earned on the original naked puts sell for May $95 and the investor has placed his cost basis down to $89.38. If the stock closes at $90.00 in September the investor can buy to close this position and walk away with a small profit.
If by September the stock is down to $87.50, the investor should be able to do the same roll out another 4 months (Jan 2013) for another small credit, basically repeating this roll out and down of the naked puts. A second roll down would place the investor at the $90.00 strike naked puts and subtracting the amount earned would place his cost basis in the stock around $86.00.
This pattern can be repeated every four months if needed, all the while lowering the put strikes being sold and stalling any loss of capital.
Making The Naked Puts Strategy #4 Decision:
To make this naked puts strategy decision is fairly simple. It is a basic roll down technique that has worked for years on blue chip stocks. A 4 month roll down is common place in large cap dividend paying stocks and McDonalds Stock is one of the larger blue chips available. All stocks have bounces and it will only take a bounce or two to turn the roll down into a winning strategy and a chance for the investor to get out with a small profit.
Naked Put Strategy Number 5 – Accept McDonalds Stock and sell deep in the money covered calls
A fifth naked puts strategy is to accept the shares in May at the $95 strike and then sell deep in the money covered calls. For example the January 2013 $85 covered calls can be sold for $8.35. The calculation then wold be $85 + $8.35 = $93.35. The investor has already earned $2.07 from selling naked puts which places his cost basis in McDonalds Stock at $92.93 which is below the break even of the $85 covered call.
The investor will also earn the May 2012, Aug 2012 and possibly the Nov 2012 dividends for a total dividend income of $2.10. His break-even on McDonalds stock then is reduced to:
$95.00 less $2.07 from $95 naked put sold less $8.35 covered call sold less $2.10 dividend income earned = $82.48.
If history is any guide stocks may continue lower over the summer months and then return for another run-up in the fall.
Making The Naked Puts Strategy #5 Decision:
Covered calls can be powerful if applied in the right strategy. If McDonalds Stock should fall below $85.00 before January 2013, I would be tempted to buy to close the January $85 covered calls early and sell another 6 months out at $85.00 to earn more income and reduce the cost basis in the stock. Deciding whether or not to use strategy number 5 is also straight forward. If the investor feels there is value in the stock he is basically risking $82.48 X 300 shares = $24744.00 and will continue to earn the dividend and can roll early and often to increase the amount of premium the covered calls bring in. If the stock falls below $85.00 it would be prudent to close the original covered calls while there is still premium in the further out covered calls at the $85.00 strike.
Naked Put Strategy Number 6 – Bear Spread On McDonalds Stock
The sixth strategy looks at doing a bear spread. This is a very simple strategy that can be altered in a number of ways. The straight forward approach is to roll the May $95 naked puts strike out from May into Sep at $95.00 and calculate the premium earned. For example at the time of writing this article the roll out from May $95 to the Sept $95 put strike will earn an additional $3.25 in put premium. This brings in a total of $5.32. The cost basis in the stock if assigned before September $95 would be $95 less $5.32 = $89.68.
Then next step is buying the protective puts. To determine the strike to buy, calculate out how much of the premium earned you are willing to give up. For example if we look at the McDonalds Stock History Chart below we can see that the low for June 2011 was around $82.00. In August the stock hit another low of $82.00.
The June 2012 $85.00 put is trading for .45 cents. I would buy the June $85 and watch the fast stochastic for any move higher in McDonalds Stock. With a move higher I would consider buying the July $87.50 put for .45 cents. My goal would be to buy protection on strength in the stock for no more than .45 cents. If possible I would naturally want to move higher. The cost for the protection into September would be .45 cents X 4 months = $1.80. For my bear put spread I would be using my protective put for profit in the event that McDonalds Stock fell dramatically. That would be my goal. However for many investors doing the spread they would buy to close their $95 puts in the event that McDonalds Stock collapse and they would hold their protective puts to ride the stock a lot lower.
NAKED PUTS Variations On McDonalds Stock
Naked Put Strategy Number 7 – Variations On All The Strategies
Finally I want to mention that there are literally dozens of variations on all the strategies I have mentioned. One of my favorites is rolling down and reducing the number of put contracts sold with each roll down. If you recall this is the strategy I did starting in April 2010 with my Microsoft Stock trade as I had sold puts at the top end of the run up in Microsoft Stock at April $30 strike and I ended up working 10 naked puts from $30.00 down to just 6 contracts for January 2012 at $26.00. In the end my naked puts expired out of the money in January 2012.
There is real beauty to that type of naked put strategy because every time I sell 1 less put, more capital is freed up that would be needed to pay for the stock if I was assigned. This capital can then be used to sell more naked puts at lower strikes.
For example, by the time I rolled from 10 to 6 naked puts from $30 down to $26, this freed up $12,000.00 which I used for selling puts at the lower strikes of $23 and $24 on Microsoft Stock. What a great strategy. My original puts earned very small net credits as I kept rolling them out and down and the freed up capital with each roll down, allowed me to earn income again but at lower strikes. As well if I had been assigned shares on all the put positions my cost basis would have been far below the original $30 strike put sold.
But that is just one variation. There are many more.
Naked Put Strategy Number 8 – Another Variation – Accept Just Partial Shares
As well our intrepid investor could also accept just 200 shares or 100 shares of McDonalds Stock and roll his remaining naked puts lower or out. Meanwhile on the assigned shares he would earn the dividend and could sell covered calls. Then each subsequent roll lower he could accept another assignment of shares and once more turn to covered calls. The result would be something possibly looking like this:
Sold 3 Naked Puts May $95 strike. Income earned $2.07 X 300 = $621.00.
Accept 100 shares McDonalds Stock at $95.00
Sell 1 January 2013 $90 covered call at $5.30 = $530.00
Earn the May, Aug and Nov Dividend = 100 X .70 X 3 = $210.00
Buy back 2 May $95 naked puts at $4.20 = ($840.00)
Sell 2 September $92.50 Naked Puts at $5.25 = $1050.00
(Below is fictional based on possibilities but no one will know what the value of McDonalds Stock might be by September)
In September if McDonalds is Lower than $92.50
Accept 100 shares of McDonalds Stock at $92.50
Sell 1 Covered call July $85.00 = $5.30 = $530.00
Earn the Nov, Feb and May dividend = 100 X .70 X 3 = $210.00
Buy back 1 September $92.50 naked put for $3.00 = ($300.00)
Sell 1 July 2013 $90.00 naked put for $4.00 = $400.00.
Total amount earned = $2411.00.
Average Cost Basis For 300 shares if assigned on final 100 shares at $90.00 = $84.46.
This strategy also allows for the investor to enjoy a run back up in the stock. If by accepting shares here and there during the upcoming months, the stock market should turn around, McDonalds stock will definitely run back up. The investor can easily buy to close his covered calls and wait for the stock to climb and then sell covered calls again to finally be exercised from his stock positions.
Naked Puts Strategy On McDonalds Stock Summary
The number of strategies than can be applied are limited only by the imagination and confidence of the investor. If there is no confidence that the stock is worthy of extended options strategies over the upcoming months, then the choice is obvious. The investor should buy to close his naked puts and sustain the loss.
Investors Fail To Study And Learn To Implement
The ability to rework a loss into a profit is something a lot of investors fail to study and learn how to implement profitably. Whether it is because it is too time consuming or the length of investment too long, is difficult to say. A lot of the problems faced by investors is fear. When markets are falling, many investors feel they just want out and they take the loss. Fear is an incredible emotion in investing and one of the primary causes of market crashes. Fear is also why I recommend to many investors who continually take losses, to realize that investing in risky assets is not for them. They should take their remaining capital and quit the stock market all together. Losing capital on blue chip dividend paying stocks, particularly those whose business is non-cyclical is a tough choice but learning from one’s past mistakes is an excellent way to not continue to repeat the same errors when selling naked puts.
Investor Relations For McDonalds Stock
Naked Puts Option Chain On MCD Stock