Selling Naked Puts: Getting paid
to buy your favourite stock!
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.
What are Naked Puts?
Here is an example that illustrates a typical trade:
XYZ is trading at $50 at the end of May, but you would rather purchase it a lower price as the market fluctuates (say, $45)
You simply sell a $45 put for $2.00, for the next expiration date (3rd week in June). You immediately receive $200 in your brokerage account
IF XYZ falls to $45 or below, you will be obliged to buy 100 units of that stock at $45 per share, which will cost you $4,500.
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 $45 is decreased by the income from the sale of your put. That is, instead of paying $45, you will effectively pay $43. (i.e. $45-$2 = $43).
NOW: say it takes six months for the stock to get to $45, and you sell a put each month; your net cost for buying the stock will be MUCH less.
OR: if the stock is in a general uptrend, you could repeatedly sell puts and never actually buy the shares.
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!
NOTE: to find out exactly how to calculate the margin requirement, and your ROM (profit), go here.
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. Use an options probability calculator (like the free one at OptionVue Research) and choose a Put in the range where the "probability of the stock price ending above the highest target" is 80% or better. 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. Wait for the Put to expire or be exercised. 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 in the next month! If you get exercised, it means that your chosen stock is quite cheap, and you have probably bought it at a discount. Either sell to cover your margin, or an even better strategy is to sell covered calls on the stock that you now own - and this way, you can even further discount the cost of the stock.
If you do not want to buy the stock, and are only using this strategy for income, you should probably be trading credit spreads instead, or you will need an exit strategy. 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. You will need to use a stop loss to exercise this trade, which you put in place as soon as you sell your first put. This way, you should come out even or only slightly under.
Selling naked puts 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 used to generate income really only works in a bull market, whereas Credit Spreads can be sold in any type of market.
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