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April 22 2011  / Strategy Article - Naked Puts
Tools For Picking Naked Put Strikes
No Free Money Here.


Introduction

 

On the CoveredCalls-NakedPuts-Options Forum, which you can join free (shameless plug for the forum) a forum member asked a question about selling puts on BIG BLUE - IBM. She was wondering what strike to pick.

 

Here is her question:

I am looking at a IBM/Oct NP. Since I have only been selling NP for a few months. I would like to get others feedback especially on the Cons of doing a NP so far out. Today IBM is selling for $168.00
The following NP's look most appealing to me.
1) $140 for $2.15 2) $145 for $2.82 3) $150 for $3.58
The $140 has a 5.69% probability of expiring below $140
The $145 has a 9.85% probability of expiring below $145
The $150 has a 15.64% probability of expiring below $150
These probabilities come from option express.

I would certainly not mind owning IBM at any of these prices and in many ways these NP's look like free money. Love to know what others think.

 

First I have to say there is no FREE MONEY here and there never is any free money when selling options. As soon as the option is sold, capital is put at risk and stocks are risky assets to be sure. Second, October for this stock is way too far out for such little earnings. It is truly a horrible investment to put capital at risk for 6 months for 2.3% or less. Better to put your capital in a mattress. Last I think the forum member has the "probability of expiring", backwards. These probabilities are of being assigned. However going out to October, I wouldn't trust any probability program. A lot happens in a month let alone 6 months.

 

Instead here are the tools I use and how I would approach any stock, including IBM to decide on strike prices.

 

The most important aspect of selling naked puts is stock selections and strike selections. The forum member question was what I would do to determine whether any of the above strikes are worthwhile.

 

10 YEAR CHART

I like to look back in time, to fondly recall the history, good and bad for the stock. Below is IBM for the last 10 years. This encompasses two bear markets, a roaring bull after the 2003 bear market ended and the most recent bull market following the end of the bear in March 2009. I can spot 3 breakouts; I can see the previous highs in IBM over the last 10 years has been around $128.00 and long term support sits solidly around the $80 - $100 valuation. The past breakouts are interesting as they show the stock ran up, reached the previous high and then pulled back to that long term support zone. The latest break out in 2010 has not followed that pattern. From 2003 to 2006 I was selling in the 80 to 100 zone. Premiums ranged but on average I was receiving 1.25% a month which was about 15% a year for 4 years.

 


5 YEAR CHART

Next I look at the 5 year chart (below). I take the long term support from the 10 year chart and drag it over to the five year. I can see that the five year support sat at between 80 to 100 for a great many years. Do you see how the run up from the last bear market in 2009 made it all the way to the previous high in the 120 to 128 zone. This is the previous high zone for the past 10 years, on IBM.  Once the stock moved above the 100 zone I had a much tougher time selling naked puts and staying out of the money. I was selling 10 contracts prior as 10 contracts at $90.00 (my most used strike up until the end of 2006 tied up 90,000 in capital - not a small amount}). However in 2007 when the stock took off and moved back to the previous high, I left IBM and returned it to my watch list.

After the crash in 08 to 09 the stock returned to its old support around $80.00. I was back to my naked put selling as IBM had returned to its old trading range. My favorite strike was 90 until Sep when again I left IBM as it worked its way to the previous highs.


1 YEAR CHART

In January 2010 the stock fell back to around 121 and held. Starting in February I sold 5 contracts each month on IBM at the $120 mark. As long as I could make at least 1% a month, I sold on each dip and continued this until my last naked put sell on August 30 2010. But 5 contracts is still 60,000 for just 500 shares. After the stock began its climb to the 140 zone, I was out and again moved it back to my watch list. Even 5 contracts at $140 I may have to cover if assigned works out to 70,000. Too much for me for 500 shares AND should the stock fall it could work its way back to the 125 and then perhaps 100.00.

 

Note how there were several pullbacks during this 8 month period and each time the stock held.  The stock had lots of support after two or three dips were tested and held as the institutional investors moved in.

 

The day and swing traders buy on the dips and sell for a quick profit and each time IBM held, I was selling naked puts at the 120 strike. The big support came from the institutions. These are the hedge funds, pensions and larger mutual fund companies. They put their computer programs into a buying mode to accumulate shares at specific prices. This helps to support this trading zone and lets me sell my naked puts.

 

The biggest investors are accumulating. It's pretty obvious in a stock like IBM. IBM has a huge float of 1.2 billion shares but institutions need a lot more stock than day, swing or larger traders. If they just simply bought all they needed, they would move the stock in a single day. Instead they sit with their computer programs set at a particular price point and buy all day long for many days each time the stock pulls back to their price point. It almost seems like a collusions among the institutions doesn't it. They keep buying but the stock goes nowhere. You'd think it would move dramatically higher, but it doesn't. As soon as the stock moves up two or three dollars, the buying dries up, so the stock falls back. 50 million dollars invested at $125.00 is 400,000 shares. With an average daily volume of around 6 million shares, it is a matter of a few months for the accumulation to end.

 

By September there is one more pullback as the institutions for the most part are done buying and then the stock turns and heads higher. To keep the stock moving, these same institutions buy and sell small quantities each day keeping the stock moving up. They pushed it to the $140 zone for about 10 to 12% returns. Then they begin to sell in November. They make sure not to sell too much as to push down the price, but they slowly unwind their positions. Most would have sold here because their returns would have been around 10% or so.

 

Now go back to the same chart and you can see how at the 140 zone the stock had a lot of trouble moving higher for a few months. The institutions are unloading and there is lots of resistance. While at this level, I could have considered selling a few naked puts just out of the money, as the unloading continues, but at $140, it is too high a valuation. 10 put contracts is $140,000. There are so many stocks to choose from at much lower valuations, I see no point at $140.00. I feel the same way about most stocks over $120 including Apple. These may be great stocks but my strategy is small amounts of income from my trades and I concentrate on 1% a month in income. In the past I have tried stocks at these prices, but when a stock falls from 150 to 70, it is much harder for me to rescue the stock than a stock that falls from 30 to 15. The loss is the same but the rescue is a lot easier. But that's for another article.

 


6 MONTH CHART

Below is my last chart showing the last 6 months of IBM. During this period where the largest investors are unloading, boutique firms and smaller investors pick up shares for another push higher. This push is more dramatic and shorter. In just a few sessions the stock is pushed from 142 to 168. The push is fast and selling is more constant. The stock moves around a lot more and you can see in the chart a pull back in March and then another quick run up. Is there a double top forming? Look at the momentum for the run up  to 168, its steady and large. MACD gives an excellent confirmation that the stock is moving high in a strong uptrend. Look at the second run up since the March selling. While the stock has climbed back up MACD does not confirm it and actually shows there are lots of sellers. Momentum is poor on this last rally. It is sharp and already dropping back despite the stock moving higher. This makes the rally suspect. If I was buying stock I would stay away, otherwise I may end up holding the stock above $160.00 and watch it perhaps fall back to 125 where there is real support.

 

 


The strikes suggested for October by the forum member were: 1) $140 for $2.15 2) $145 for $2.82 3) $150 for $3.58 - all of which are above true support in this stock. Only the $140.00 is within what may prove to be a small band of support but since 140.00 is a new high in the last 10 years, I would be a lot more comfortable in another stock. At $2.15 for an Oct $140 put, the return is 1.53% before commissions, and the capital at risk is $14000 for every put contract sold. This is far from "free money".

 

Summary

When selling naked puts, it is a strategy of earning income to reduce stock ownership. I have found over years of selling naked puts that through using basic tools I can chart stocks and pick ranges that I would prefer to stay within and to minimize risk of assignment at high levels. While I am interested in owning the stock, it is after earning capital through selling naked puts to augment the cost of stock ownership. By not studying charts and picking high, inappropriate levels to sell naked puts, I can find myself owning shares at levels some stocks may not revisit for what could be years. I believe through doing some homework in advance I can do my best to avoid selling puts at the wrong level and or the wrong time.


 


 

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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