December 15, 2005

The Naked Put
by John Brasher, CallWriter Publisher

Finally, my long-awaited article on selling naked puts! The very idea of writing naked puts seems a little racy, doesn't it? But, counter-intuitive as it may seem, the fact is that put writing - done for the right reason and at the right time - can be a pretty conservative strategy. There actually are three principal strategies for writing puts, and this article will touch on all of them.

The Put Option and Put Buying A put option (or "put") gives its holder the right, but not the obligation, to sell shares of the underlying stock at a set price (the "exercise" or "strike" price) for a fixed period of time. One buys a put when bearish on the underlying stock, expecting that the stock's price will fall, which will make the put more valuable. The put buyer typically will exercise the right to sell the shares at the strike price when the put option is in the money and the put has no remaining time value. A put option is "in the money" (ITM) when the stock's price is below the strike price. While investors sometimes buy puts in order to protect a long stock position, buying puts in hopes of a stock decline is a speculative strategy. Since stock options expire, they are wasting assets. Buying puts is therefore a bet on the stock's direction. To profit from buying puts, the trader consistently must be right about the stock's direction, and also have the timing of the price decline right. The flip side of put buying is of course writing puts - being a put seller. There are good reasons for writing puts, and it can provide an excellent income. Only about 10% of all stock options are exercised. The other 90% are either traded out or expire worthless, which means that the overall odds are commandingly in the put writer's favor. Careful trade selection can greatly increase the odds and yield an overwhelmingly winning average. Writing the Naked Put The naked put is an uncovered position, and the rationale for writing puts is simply to capture premium on their sale. It is therefore an income strategy, not a speculative strategy. The put buyer depends on the stock declining enough to make the long put position valuable, but the put writer pockets premium on every trade. A trader who writes naked puts is neutral to bullish on the underlying stock and believes it will hold its price or advance. It exposes the put writer to a loss if the stock drops before the put expires. Essentially, the put writer is taking advantage of time decay. Options lose value as they approach exipiration, until finally they lose all value at expiration; and the loss in value is the greatest in the last 30 days before expiration The naked put has the same risk/reward profile as a covered call. This should not be surprising, because the covered call is just a synthetic way of creating a naked put. For this reason, stocks that make good covered call candidates also make good naked put candidates. Just as the covered call writer should never write calls on a stock he or she is unwilling to own (if not called out of the stock, you do own it), the naked put writer should always be willing to own the underlying stock. In fact, one of the naked put writing strategies featured in this article has as its goal acquiring the stock at a discount. Naked Put Strategies There are three principal strategies for which naked puts are used. They are: Strategy Goal The Discount Write Employed to acquire a stock you want at a lower price than current market. If the stock is not put to you, just enjoy the income. Short-Term Write Used not with a goal of acquiring the stock but to generate an income stream from the systematic writing of OTM puts. Long-Term Write Generate an income stream from put writing by closing trades (buying back puts) as they become cheaper, either through time decay or a stock advance. The discount and the short-term write look very similar and could in some cases be identical. The main difference is that the short-term writer would more likely write out-of-the-money (OTM) puts in order to lessen the chances of being assigned the stock if it pulls back for a few weeks. The discount writer on the other hand is actively looking to buy the stock and would more likely write an at-the-money (ATM) or slightly ITM put, both to get a larger premium and to increase the chances of being assigned. The stock could go up, frustrating the discount writer's goal of acquiring the stock more cheaply, in which case, the trader simply pockets the premium and keeps writing puts on the stock.   Discount Write Short-Term Write Long-Term Write Trade Orientation Bullish - why else seek to own it? Neutral to Bullish Bullish Option Expiration Current month: usually 15 days or less Current or next month, up to 60 days until expiration, but can be very short term 90 days or more until expiration; frequently 4-6 months out Trade Duration Usually through expiration; re-write if stock not assigned. Usually through expiration As long as it takes, seldom through expiration Trade Goal To buy stock at a discount; trader picks up premium income if not assigned Creaming the trade for premium; goal is not to get assigned the stock Use stock advance and/or time decay to repurchase puts at a profit Stock Characteristic Should be bullish, but can be used on any stock you want in portfolio Uptrend preferable; solid support above put strike is essential and should be a stock you're willing to own Stock quality is less important; it should be in uptrend and volatile (you want it to spike up for a quick close on the trade) Put Strike ATM or slightly ITM, since the goals are to maximize premium and increase chance of assignment OTM, to lessen the risk of being assigned the stock ATM or slightly ITM to maximize premium Assignment Risk High, which is what the trader desires Low, unless stock dips below put strike and time value is gone Low on pullbacks, until put gets within last 30 days Trade Risk That stock price gaps down, resulting in assignment of falling stock; in that event trader must roll puts or be assigned Same; but trader is unlikely to be assigned until time value gone; can always close or pre-emptively roll puts Longer time horizon and the low likelihood of assignment gives trader time to wait and see in event of stock pullback Time Decay Severe, but time decay is not relevant to trade strategy Rapid, since put is in last 30-60 days. Usually not economical to close trade unless stock advance lowers put premium Slow; put loses value slowly until last 45 days or so. To avoid holding the position for most of put's life, select a stock in good uptrend The long-term writer actually wants a bullish stock, because the goal is to close the trade in a month or two based upon a price advance that makes it possible to buy back the puts cheaply enough that an acceptable profit is created. As the stock's price increases, the long-term put becomes increasingly OTM, and the put's premium drops accordingly. At some point, it drops enough to hit the writer's profit target. Sure, time decay will accomplish the same result, but who wants to wait four to six months to close the trade? The longer the trade is on, the lower the return for the unit of time lapsed. For this reason, the long-term writer also wants a volatile stock that can really move around, because a price spike is the fastest way to close the trade at a nice profit. Because expiration is months out, the long-term writer is very unlikely to be assigned on a stock dip and can afford to wait and give the stock time to recover; there is rarely a need to modify the trade by rolling out or otherwise. The long-term writer is the purest trader of the three, since the goal is to let the stock's advance, or operation of time, create a successful trade. Cash-Secured Puts and Margin According to the terms of a put contract, a put writer is obligated to purchase 100 shares of the underlying stock at the put's strike price, if assigned. If the trader is assigned and does not have the means to buy the shares assigned, the broker must make the trade good. Thus in order to write naked puts, the trader must have on deposit with the brokerage firm cash (or equivalent unencumbered value) in an amount equal to the put's strike price minus the premium received. This is known as a cash-secured put. This cash or value is essentially frozen, since it is securing the broker on a particular trade . Because the funds are not available for other purposes, writing naked puts involves an opportunity cost. Alternatively, your broker may allow you to write the puts on margin, which is a loan from the brokerage firm. When writing on margin, you need not secure the entire risk amount but only an amount equal to the initial margin requirement. The initial margin required generally will be approximately 20% of the put strike. The minimum amount required is a more complex calculation than this, but there is little point working through examples, since every broker will apply its own margin requirement. Note that the initial margin is adjusted after the trade's open, and this adjusted amount is known as the maintenance margin. Margin increases as the stock declines, and decreases as the stock moves higher. Margin is an extension of credit, not a right, and your broker may (if it offers margin at all) impose a much higher initial margin requirement. As with any trading, margin considerably increases the trade's profit potential (and does not tie up as much capital in your account), but also correspondingly increases your risk. The Conservative Side of Put Writing The put writer, while executing a trade with a neutral to bullish outlook, is not looking to participate in the stock's advance. The writer only seeks to generate an income from selling premium. And as with covered calls, it is possible to consistently select stocks that will hold price or advance. Some doubt that statement, but successful trading is done all the time. In fact, successful covered call writing is done all the time. So why is the notion of writing puts with consistent success in any way odd? Certainly, the discount write is considered the lowest-risk approach to put writing, since the goal from the outset is to acquire the stock. Actually, the discount write is a very conservative trading strategy. The alternative approach to making the most advantageous possible stock buy is to put in a limit order below the current market price and hope for a fill, which leads to unfilled orders much of the time! This is particularly annoying when the stock is holding price or moving up. But by writing a put, the discount writer gets the stock at a nice discount (the time value part of the premium); sometimes a whopping discount. Too many traders and investors instinctively flinch at the idea of naked put writing. Yet the greatest risk (really a theoretical risk) is that the stock price goes to zero without a chance to exit the trade and mitigate damages. But isn't that the same risk the stock buyer undertakes? Unlike the naked call, which presents a risk that at least theoretically is unlimited, the maximum possible loss on a naked put is the amount of the put strike, and in my experience that very seldom occurs. There are examples like Enron or Delphi, but neither of them actually went to zero (but close), and neither made their entire drop in a single day. Both would have entailed loss to the naked put writer, no matter how quickly the trader closed - but traders and investors long the stock lost their shirts, too. You can't take risk out of trading, but there is no reason to exaggerate put writing risk in our own minds, either. The truth is that the risk is really no worse than with just about any other trade. But be that as it may, brokers are more skittish about naked put trades than covered calls (which present a virtually identical risk profile), and require a higher account approval level for options trading. This issue's Question and Answer: Predicting Early Exercise of Options Question:   Stock options can be exercised before expiration, but how do I know when to expect this? Answer:  Options on U.S. stocks are American-style options, which can be exercised at any time before expiration, as opposed to European-style options that can only be exercised at expiration. Because it is almost always more advantageous to sell (flip) an option than to exercise it and buy or sell the stock to capture gain, option holders usually will flip them instead of exercising. However, close to expiration, in-the-money (ITM) options sometimes will lose all time value and trade exactly at parity (the intrinsic value). When this happens, there is no advantage in flipping the option, and any profit can only be realized from exercise. There is no point for the option holder to wait in that situation, so exercise occurs. Early exercise can also occur if there is little open interest in the option series, thus little liquidity, and a big spread exists between the bid and asked prices. When liquidity is low, exercise may result in a better price than flipping the options; or the lack of liquidity may make selling more than a few contracts problematic. But there are no guarantees, and I have seen early exercises of ITM calls that made no sense to me; it happens. Early exercise does not occur with at-the-money or out-of-the-money options, since exercise confers no economic advantage.

Good luck and good trading!