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April 12 2010  / Strategy Article - Selling Stock Options - selling puts
Understanding Selling Puts
Introduction

This is a brief introduction to understanding what is meant by selling puts or a naked put or cash secured put and how it is used in a trade. This brief outline will assist in forming a basis by which an investor can then expand their knowledge to determine the suitability of selling puts for their investing objectives.
Selling a naked put in its most basic form is selecting a strike price for the put option, selling that put strike which then gives someone the right to sell you (assign) the stock to you at the strike price you have sold.

 

Fictitious Example:

                    STOCK ABC is trading at $50.00 on April 12 2010

                    The May 2010 $46.00 put is $1.00 bid and $1.10 ask  (1 put = 100 shares)

                    Investor sells quantity of 1 $46.00 put for $1.00 premium

                    Breakeven on the Stock is $46.00 less $1.00 = $45.00

                    Income Earned  $1.00 X 100 (shares)  = $100.00

                    Capital at risk - $4,500.00  

                    Return on Risk - $100.00 / $4,500.00 = 2.22%

                    Cushion between breakeven and present trading price = $50.00 - $45.00 = $5.00 or 10% - Therefore the stock must fall 10% before the breakeven is reached which will put the trade in jeopardy of assignment.

 

Why Is It Called A Naked Put?

It is called a "naked put" when sold, because the investor who has sold the put, is "naked" the shares - or to be even more simple - the investor does not own the shares against which the put has been sold. The investor then is "short" the shares in their account.

 

What Is The Maximum Risk?

The maximum risk of a naked put is the strike price the investor has sold, less the premium made by selling the naked put, which in my example is $100.00. Therefore as per the example of our fictitious stock ABC, which was trading at $50.00, the investor sold the $46.00 put, so the risk is that should the stock fall to $0.00, the investor is at risk of having to pay $46.00 minus any premium earned for selling the naked put, for the stock. This means the total capital at risk is $4500.00. While this may seem shocking, it is easy to stop such an event simply through buying back the naked put if the stock appears to be falling and the investor becomes concerned that the stock may be collapsing to a price level they are uncomfortable with.

 

Buy To Close A Naked Put

It is important when selling naked puts to consider whether or not you would want to own the stock at the strike level you are considering selling naked puts at. A put that is sold for $1.00 can easily end up costing $3.00 to buy back should the stock fall below the strike price sold. In other words if you sold a naked put on our fictitious ABC stock for the $46.00 strike for $1.00 and the stock falls to $42.00, you will be assigned unless you either buy back the put you sold, which is called "buy to close", or you roll further out in time at the same strike price or you roll further out and down to a lower strike. (rolling naked put strategies are covered in other articles)  If at $42.00 you decided to buy back the naked put, in my example stock ABC, it would cost more than $4.00 to buy back.

 

Use Of A Stop Loss

By buying back the naked put, you have eliminated your obligation to purchase the shares of the stock and you will not be assigned shares. If you buy back the naked put for more than you received in premium when you sold the naked put, then you have though taken a loss on the option trade. This is why many investors who routinely sell naked puts, establish a stop loss on their trade. A stop loss is the value of the put which they will re-purchase it for in order to end any further losses in the position. Just as investors use a stop loss on a stock, an option seller will do the same. It is important to establish a trading strategy before selling the naked put so the investor has clear price points at which they will buy back the naked put should the trade not work in their favor.

 

When Can A Sold Naked Put Be Assigned?

Theoretically, when an investor has sold a naked put, they can be assigned at any time up until expiry. In reality a sold naked put can be assigned at any time when the stock falls to or below the naked put strike price that has been sold. Therefore in my fictitious example of stock ABC it falls to $46.00 or lower, the investor can be assigned shares right up until the day of expiry.

 

Bullish Or Ranged Bound

When an investor sells a naked put, they are normally bullish that the stock will not fall or at the very least it will go sideways. Most investors sell naked put for income and usually sell one month out in time. This is because time decay is the most rapid in the shortest time frame. Therefore the put seller hopes that within the one month period the stock will stay above the strike price sold, allowing the put seller to capture all of the premium earned through selling the naked put. 

 

Buy Stocks At A Discount

Another reason for selling a put is to pick up the stock at a discount to its current price. For example, if our fictitious stock ABC is trading at $50.00 and the investor would prefer to purchase the stock at $46.00, then he would sell a put for $46.00 and he is paid the premium from the option sold. Then should the stock fall to $46.00 or lower, the investor would be assigned (often referred to as exercised) shares at $46.00.

The advantage is that not only does the investor end up owning the stock for $46.00 rather than $50.00, but he also keeps the put premium he made when he sold the put. If, for example the put was sold for $1.00, then the investor's cost in the stock is actually $46.00 less $1.00 which equals $45.00.

 

On the other hand if the stock does not fall to $46,00 then the investor keeps the premium and can attempt to sell another naked put for the next month out.

 

Selling Puts Monthly For Income

By selling puts every month and never being assigned, an investor is earning an income while waiting for the stock to fall in value. The income that is being earned is reducing his cost of the stock so that, when eventually he is assigned shares, his cost basis in the stock is reduced by whatever put premium he has earned through selling naked puts.

 

Selling Puts Are Net Credit Trades

Selling a naked put is a net credit trade. In other words an investor who sells a naked put receives a premium for selling the put. The premium is the price the put was sold for. That premium is paid to the investor within 24 hours. Therefore the profit earned from the trade is deposited to the naked put seller's account within one day of the trade even though the trade may have a month or longer before it expires.

 

Maximum Profit

The maximum amount an investor can make on the single naked put trade is the option premium they have received from the sale of the naked put. In my example of ABC, the investor will earn $100.00.

 

To recap:

 

ADVANTAGES:

1) Selling naked puts consistently and with great care can result in a regular monthly income from rising or range bound stocks.

2) Selling naked puts can often allow the investor to pick up stock at a discount to its current price should the stock fall and the investor be assigned shares. The premium received also reduces the cost of the entry into the stock.

 

DISADVANTAGES:

1) In theory, Naked Puts expose the seller to almost uncapped risk, should a stock they have sold naked puts against, fall to zero in value and the naked put seller does not buy to close their sold naked put options.

2) Should a stock begin to fall and the investor accept assignment, they may be accepting shares in a stock that has fundamentally changed and is now collapsing.

 

SUMMARY:
This is a simple definition of naked puts. There are numerous trade strategies and details on how to learn successful naked put selling.

 

 

 


 

Disclaimer: There are considerable risks involved in all investment strategies. Trade at your own risk.
Stocks, options and investing are risky and can result in considerable losses. None of the strategies, stocks or information discussed or presented are financial advice, trading advice or recommendations. Fullyinformed.com is a private website. Everything presented and discussed are the author's ideas and opinions only.
By using this site, you agree to be bound by its terms of use. The full terms of use can be read here. If you do not agree to the terms of use, do not use this site. The author of fullyinformed.com assumes no liability for topics and ideas discussed, errors and omissions, ads and their content and external links. Any corporate insignia used are registered trademarks of their respective company or corporation and are being used for identification purposes only. All material copyrighted by FullyInformed.com. Reproduction in whole or in part prohibited. Copyright 2008

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