Options Theory: Naked Put
Today we turn to a popular cash flow strategy: the naked put. It’s arguably the simplest of all premium selling plays and boasts many attractive characteristics. Chief among them is its high probability of profit and positive theta. Let’s investigate.
Get Paid for a Promise
Before we get too far along it’s worth mentioning the naked put is also known as a short put and can be initiated by selling to open a put option. Perhaps the best way to think about the trade-off when selling options (puts or calls) is you are getting paid for a promise. When you sell a put, you are obligating yourself to buy stock (that’s the promise) in exchange for getting paid a premium. There are two potential outcomes. If the put sits out-of-the-money at expiration, then it will expire worthless allowing you to pocket the initial premium received. Imagine that! You got paid for a promise you didn’t have to make good on! The alternate outcome is if the put sits in-the-money at expiration, then you will have to make good on your obligation to buy the stock (through a process called assignment).
By the way, that second outcome may not be a bad thing as it tees you up to potentially sell covered calls. And besides, the price that you’re obligated to buy at is always at a discount to the stock price at trade entry. Indeed, the naked put sets up a potential win-win.
The Downside is Limited Upside
Nowhere is the absence of free lunches more apparent than in the financial markets. There is a cost or, more accurately, a trade-off associated with the higher probability of profit accompanying the naked put trade. We’re talking about the limited reward. See, much like an insurance company’s potential profit is limited to the monthly premiums received from their customers, your max gain with put selling is capped at the credit received upon trade entry. And that can be slightly depressing if the stock shoots to the moon.
You can exercise some control over the level of disappointment, however. For starters, make sure the premium you receive offers a good enough return. 10% is a good starting point, but personally, I’ll drop that down to 5% if the probability of profit is high enough. Another tactic for better milking strong rallies in a stock is to continue redeploying new naked put trades when your existing position approaches max gain.
A Picture is Worth a Thousand Words
You should know by now that I’m a big-time fan of risk graphs. One way to illustrate the advantages you can tap into with the naked put is to compare it to a long stock position. Remember, the risk graph of a stock position is a 45-degree line sloping from bottom left to top right. It boasts unlimited reward and unlimited risk (until zero, at least). It’s a pure 50–50 bet. You’ll see what I’m talking about in the blue graph below. It shows a 100 share position in XME, purchased at $35.55:
Now, take a gander at how the graph of a naked put compares (orange line). This is a short Jan $35 put for a 55 cent credit. First, do you notice how the graph flattens out, regardless of how high the stock rises? That’s the limited reward part. Our profit is capped at 55 cents, tops. But we capture that whether the stock grows, stagnates, or even falls a bit. The profit zone, then, is much broader for the short put play. In fact, the entire box highlighted in yellow shows how the naked put generates a profit even as the stock position would be losing.
Perhaps the best stack-up is to view the different break-even points. While the long stock sits at the entry price of $35.55, the naked put is all the way down at $34.45. This shifting of the breakeven point to the left (that is, to lower prices) is what elevates the probability of profit.
Finally, if the stock plunges, the naked put loses less money than a straight stock purchase. Curious enough, many novices view put selling as risky, but don’t think twice about buying stock. It’s an opinion born of misinformation and ignorance. No matter how you slice it, naked puts are safer than buying stock.
