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1.4. Short (Naked) Put

ProficiencyDirectionVolatilityAsset LegsMax RiskMax RewardStrategy Type
N/A
IntermediateBullish Short PutCapped[*]CappedIncome


[*] Risk uncapped until the stock falls to zero.

1.4.1. Description

Selling a put is a simple, short-term income strategy. A put is an option to sell. When you sell a put, you have sold someone the right to sell. As the stock falls, you may be obligated to buy the stock if you are exercised. Therefore, only sell puts Out of the Money and on stocks you'd love to own at the strike price (which is lower than the current stock price).

The maximum risk of a naked put is the strike price less the premium you receive. Some people consider this to be an unlimited risk profile, and others consider it to be limited risk. A compromise is to consider it unlimited until the stock falls to zero—in other words, unlimited until the stock falls to zero.

Steps to Trading a Naked Put
1.
Sell the put option with a strike price lower than the current stock price.

  • Remember that for option contracts in the U.S., one contract is for 100 shares. So when you see a price of $1.00 for a put, you will receive $100 for one contract.

  • For S&P Futures options, one contract is exercisable into one futures contract. If the option price is $1.00, you will pay $250 for one futures contract upon exercise.

Steps In

  • Try to ensure that the trend is upward (or sideways) and identify a clear area of support.

Steps Out

  • Manage your position according to the rules defined in your Trading Plan.

  • Hopefully the stock will rise or remain static, allowing your sold option to expire worthless so that you can keep the entire premium.

  • If the stock falls below your stop loss, then exit the position by buying back the puts.

  • Time decay will be eroding the value of your put every day, so all other things being equal, the put you sold will be declining in price every day, allowing you to buy it back for less than you bought it for, unless the underlying stock has fallen of course.

1.4.2. Context

Outlook
  • Bullish— You are expecting the stock to rise or stay sideways at a minimum.

Rationale
  • To pick up short-term premium income as the share develops price strength.

  • To lower the cost basis of buying a share (if the put is exercised).

Net Position
  • This is a net credit transaction because you receive a premium for selling the put.

  • Your maximum risk is the put strike price less the premium you receive for the put. This is considered a high-risk strategy.

  • Your maximum reward is limited to the premium you receive for the option.

Effect of Time Decay
  • Time decay works with your naked sold option. To take advantage of the maximum rate of time decay, sell the put in the last month before the option's expiration.

  • Don't be fooled by the false economy that options with longer to expiration are more lucrative. Compare a one-month option to a 12-month option and multiply the shorter option price by 12. You will see that you are receiving far more per month for the one-month option.

Appropriate Time Period to Trade
  • One month or less.

Selecting the Stock
  • Choose from stocks with adequate liquidity, preferably over 500,000 Average Daily Volume (ADV).

  • Try to ensure that the trend is upward and identify a clear area of support.

Selecting the Option
  • Choose options with adequate liquidity; open interest should be at least 100, preferably 500.

  • Strike— Look for OTM (lower strike) options, below the current stock price.

  • Expiration— Give yourself as little time to be wrong; remember that your short position exposes you to uncapped risk (until the stock falls to zero) and that time decay accelerates exponentially (in your favor when you're short) in the last month before expiration, so only short the option with a maximum of one month to expiration, preferably less.

1.4.3. Risk Profile

Maximum Risk[Put strike - put premium]
Maximum Reward[Put premium]
Breakeven[Put strike - put premium]


1.4.4. Greeks

1.4.5. Advantages and Disadvantages

Advantages
  • If done correctly, you can use Naked Puts to gain a regular income from rising or rangebound stocks.

  • The Naked Put is an alternative way of buying a stock at a cheaper price than in the current market. This is because if you're exercised, you're obligated to buy stock at the low strike price, having already received a premium for selling the puts in the first place.

Disadvantages
  • Naked Puts expose you to uncapped risk (as the stock falls to zero) if the stock falls.

  • Not a strategy for the inexperienced. You must only use this strategy on stocks you'd love to own at the put strike price you're selling at. The problem is that if you were to be exercised, you'd be buying a stock that is falling. The way to avoid this is to position the put strike around an area of strong support within the context of a rising trend. A Fibonacci retracement point would be the type of area you'd use to position your naked put strike . . . well below the current stock price.

1.4.6. Exiting the Trade

Exiting the Position
  • Buy back the options you sold or wait for the sold put to expire worthless so that you can keep the entire premium.

Mitigating a Loss
  • Use the underlying asset or stock to determine where your stop loss should be placed.

1.4.7. Example

ABCD is trading at $27.35 on May 12, 2004.

Sell the June 2004 $25.00 strike put for $1.05.

You ReceivePut premium $1.05
Maximum RiskStrike price - put premium $25.00 - $1.05 = $23.95
Maximum RewardPut premium $1.05
BreakevenStrike price = put premium $25.00 - $1.05 = $23.95
Return on Risk4.38%
Cushion (from Breakeven)$3.40 or 12.43%


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