Tuesday Trading Tutorial - Selling Naked Puts - December 16, 2008

Following last week’s discussion of writing covered calls, this week’s article will cover a similar concept in options trading known as Put Selling, or Selling Puts.

Selling a put is very similar to a covered call, only with a somewhat different perception. With a covered call, you must own the stock. Selling a put, however, does not require you to own the stock in advance. This would be considered a “naked” position.

When you write a covered call, you are theorizing that the stock will go up or stay the same. Therefore, your risk involved in the investment of losing money is only if the stock price falls beyond your adjusted cost basis. You make money with a covered call when the stock goes up or even just trades sideways.

When you sell puts, a "premium" is collected for the trade and is thus deposited into your account on the day your trade is entered. When selling a put, it is possible to make money investing in the options in several different ways, including when the stock is going down.

When selling an out-of-the-money put, if the stock goes up, your put expires worthless and you retain the premium. If the stock stays unchanged in price, your put would also expire worthless, leaving you to earn the premium received at the beginning of the trade.

If the stock drops less than the difference of the selling price and the put, you would again earn the premium. If you were to sell a QWE $20 put at $19, and received $2 in premiums at the beginning of the trade, you would still earn $1 on the deal, even though the price of the stock dropped below the purchase price.

For more advanced investors, if the stock shows a temporary weakness, you can buy back the options and roll it out to the forward month. The investor, basically, would buy back the current option, and then sell the put for the next month. Essentially, this would buy the investor extra time for the stock to move in a more positive direction.

If an investor needed to roll out to the forward month, he would first need to buy back his put option. If the investor sold the put for a $3 premium, and had to buy back the put at $2, he would only profit $1 per contract for the trade. However, the investor would then sell another put on the same security for the forward month, thus receiving an additional premium, say of $2.

As the seller of puts, the time-decay within options works in favor of the investor. Time-value in options continuously decline with time and eventually hits zero at time of expiration. Therefore, it is wise for an investor to sell puts with one month or less until the expiration date.

A put selling strategy possesses several great benefits. Not only can it be used in an IRA account, but it can also be used as a long-term investing plan.

One benefit for selling puts would be if the puts you sold were exercised, then you would be obligated to purchase the asset at the exercise price. Since you have already agreed to purchase the asset at the exercise price if put to you, the price of the falling underlying asset is further discounted by the option premium that was collected at the opening of the trade.

If you were to sell a QWE $40 put contract and receive $4 in premiums, and the stock was trading at $35, if the contract was put to you, you would purchase the stock for a cost basis of only $31 per share. the is calculated by taking the selling price, $35 a share, and subtracting the $4 premium received for selling the put, thus totaling $31.

There are only a few that will make this trade lose money. First, if an investor were to hold a falling stock past its strike price and sell, a situation would be created wherein the investor would lose money on the investment. If you were to sell a $20 put contract and get a $2 premium and let the price of the underlying stock fall as low at $15, even with the $2 premium the $18 cost basis is higher than the current stock price, thus resulting in an overall loss of $3 per contract.

A second way your money could be lost in selling a naked put would be if the stock drops below the put price, minus the premium received, and someone puts the stock to you, you would lose money. Similar to the example given above.

If the underlying stock is put to you, a wise investor could turn around and sell covered calls on the stock to help reduce their cost basis of the stock even further.

For example, if QWE stock trades for $65 and its front-month $60 puts trade for $3. A put writer would sell the $60 puts into the market and collect the $300 ($3 x 100) premium per contract. The investor thus expects the price of QWE to trade above $57 in the coming month. However, the investor is exposed to escalating losses if the price of the stock falls below $57. At a stock price of $55, the put seller is still obligated to buy shares of QWE at the strike price of $60.

To close out a put position prior to expiration, the put seller would buy back the put contract in the open market. If the price of the stock has remained unchanged or increased in value, the put seller will most often earn a profit on their position due to the loss of time value in the option.

If, however, the price of QWE, from the example above, had fallen dramatically, the put seller will be either forced to buy the put option at a much higher price or forced to purchase the shares at $60 when they are put to them.

In the case of QWE with the stock trading at $55, the put seller would be either forced to pay $500 to repurchase the put at expiration or forced to have the shares "put" to them at $60, which will require $6,000 in cash or margin. In either case, the put seller generates a loss of $200 at expiration. The $200 loss is calculated as the ($5500), current market value, - ($6000), the price paid for the stock, + ($300), premium collected at the beginning of the trade.

Check back next week when we explore another options trading strategy, credit spreads. Have a great week in trading and hope to see you next week.

For more information on the stock and options markets check out the wealth of information at BetterTrades.