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Selling Naked Puts is a great option trading strategy, with ROM (Return on Margin) similar to that of selling credit spreads, and certainly no more risky in practice (although in theory, it looks quite scary).
When you sell a put on a stock, you are setting yourself up to buy a stock at a price that suits you.
For example:
XYZ is trading at $50
You can sell a $40 put, which means that IF XYZ falls to $40, you will be required to buy 100 units of that stock, which will cost you $4,000.
BUT: you have sold the Put for $2.00, and have earned $200 as a result. Therefore, your net cost for buying the stock at $40 is decreased by the income from the sale of your put. That is, instead of paying $40, you will effectively pay $38. (i.e. $40-$2 = $38).
NOW: say it takes six months for the stock to get to $40, and you sell a put each month; your net cost for buying the stock will be MUCH less.
What a great strategy!
HOW ABOUT? Why not pick a stock in an uptrend (see Trend Analysis), and then month after month, sell naked puts. You can make a great income from this!
Well then, why not?
The ONLY drawback to this strategy is that most brokers require quite a high margin. That is why this is called a “Naked” put - it does not have the protection from a major crash that credit spreads have. In the event that the stock does crash to your chosen strike price, your broker will want to be sure that you have enough money to buy the stock at that price. The formula differs between brokers, but the margin requirement usually works out to be about 12% of the full purchase price of the stock, should you get exercised.
Why this steep margin requirement? Well, in theory, if you buy the stock at the strike price, it is usually because the stock is crashing....and could continue to crash, until the stock is worthless, leaving you badly in the lurch with a stock for which you paid too much. Sure, this could happen....on a bear run that includes all the grizzlies in Canada and Alaska getting rabies and rampaging through New York City. However, just to be safe, the brokers keep a good safety net in place!
How to sell Naked Puts
Firstly, pick your stock based on trend analysis. You need a stock that is trending upwards or sideways. Make sure that the general market trend is a match, and that there are no earnings or dividend dates in the next month.
Secondly, pick a put trade. Because you are not offsetting the trade with a simultaneous purchase as you would with a credit spread, you can go quite a bit further out than the 80% mark - you can pick a put that has less than 10% or even 5% chance of being exercised, and still make a good return. Pick an expiration date that is no longer than 30 days out - you want your option to expire so that you can sell another one! Make sure that you have enough margin (if you don't know how to work this out, run a similar paper trade on your options software, and see how much cash you will need to have available in case the trade turns against you.
Third, watch your trade. If you have picked a good trend, your options should expire worthless by the next expiration date, at which time you can sell another one!
If your trade goes so badly against you that it beats even the outstanding odds in your favour, DO NOT WAIT TO EXPIRATION to be exercised, so that you are forced to buy the stock (unless you REALLY want the stock). Buy the option back before it goes ITM (this is why you need your margin available), and sell another naked put at a lower strike price. This way, you should come out even or only slightly under.
This is a great trading strategy if you have enough money to cover the margin requirements. It is safe, risk averse and very profitable. If you are nervous at the idea, or don't have enough money to cover the margin, then selling Credit Spreads is as profitable and probably even safer as an option selling strategy.
Final note: this strategy really only works in a bull market, whereas Credit Spreads can be sold in any type of market.
Return from Naked Puts to the Home Page
Review the basis of this strategy: analysing a trend
Or: Move on to find out about selling Credit Spreads
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