The strategy of selling naked puts is one of the soundest, least risky of all option strategies. Without getting too technical, this strategy permits for the underlying stock to rise, stay at the same price, and even fall a little without generating losses, unlike buying calls which require a bullish upward move, or its opposite, buying puts, which requires a bearish downward move by the underlying stock. Not so with naked puts.
Here is a very abbreviated lesson in selling naked puts:
Puts are options which permit the owner of the put to sell the underlying stock at the strike price of the put, but obligate the put seller to buy the underlying stock if put to him.
BUY a put - you own the right to sell the stock.
SELL a put - you obligate yourself to buy the stock.
Why would you want either one of these conditions? Say your grandmother gifted you a stock a few years ago, and it has gone up in price. Let's say Altria, symbol MO. At the time she gave you the stock, its price was $15. Today it is trading at $36.00 or so. To protect your gains, you could buy a put on MO. Put (and call) options are designated in strike prices and expiration dates. Usually, the farthest out in time, the more costly the option; and the deeper in the money the strike price, the costlier it is.
Some definitions are needed here:
ITM (in the money) put - the put strike price is above the current market price.
OTM (out of the money) put - the put strike price is below the current market price.
Stock: Altria
Symbol: MO
Market price: $36.00.
Put strike: $35 - OTM
Put strike: $39 - ITM
Got it? Take a look at the following options chains for MO:
The graphic is as follows: For the bearish put, the put you buy (also known as the long put), the graphic would look like this:
Conversely, to sell a put, the graphic looks like this:
Again, the P/L increases as the stock price decreases.
The strategies available with selling puts are many, to wit: generate income, generate immediate usable cash into one's account, hedging stock, and the possibility to buy stock at a discount.
Let's get back to MO. At its current price of around $37.00, selling a Jun2014 36 strike put brings in 1.94. Keep in mind that options are sold as contracts, and each contract controls 100 shares of underlying stock, therefore, 1.94 per contract would equal $194.00 in your account immediately.
What are the implications? You have sold someone the right to "put" the stock (MO) to you at a price of $37.00. This is ITM, as this strike price is higher than the current market price of the stock. Why would the put owner want to sell you the stock at $37.00? If MO were under that price at expiration. It makes sense: If the buyer of the put wanted to protect his own stock at a level of $37.00, and the stock declined to $35.00, he owns the right to sell his stock at $37.00. After all, he bought that insurance policy guaranteeing him that right. You, as the seller of that insurance policy, have agreed to have MO "put" to you at $37.00, and for that agreement, you got paid a premium of $194.00. Just like any insurance company collects premiums year after year, sometimes it has to pay out, and it is obligated to do so because it has sold you that right. Some simple calculation reveals that your break-even cost on MO shares would be $35.06 ($37-1.94). That is almost $1.00, or about 2.77% less than the current market price. Oh, by the way, that would be for a mere three months! Annualized, that return would be 11%. Not too bad.
But, you may ask, what happens if the stock RISES above my sold strike of $37.00? Well, then, you keep the entire $194.00, and move on to the next trade. In either case, you keep the $194, whether the stock is put to you, or rises above the strike: You keep the $194.00.
You have several choices when you sell a naked put: You may hold onto it, and watch the stock to see if it rises above the strike; you may elect to have it put to you if you absolutely love it and want to own it, but at a discount; or you may close your position by buying back the put! In the example, you received $194 for selling someone the right to put you the stock. Suppose you hear some news that makes you change your mind about owning MO? Simply go to the marketplace and buy back to close you naked put. No muss, no fuss. The cost you will incur is whatever the stock/option prices are at the time you wish to buy back to close. If the stock has moved up - in your favor - the put option will be cheaper, thus buying it back more cheaply realizes a profit for you. The opposite may be true - the stock is lower on the market, and thus your option may be costlier (depending on how much time remains to expiration). Either way, once you buy back to close your position, your obligation is likewise ended.
Let's get back to the object of this entry: Lawrence Meyers' article in InvestorPlace (above).
In fact, he proposes establishing naked put positions on 3 stocks, Dollar Tree (DLTR), Encore Capital Group (ECPG), and Starbucks (SBUX).
At the time the article was written, DLTR was trading at $54.33, and the April 55 puts were yielding 1.70. ECPG was trading at $48.69, and the April 50 put was yielding 2.10. SBUX was trade at $73.07, and the April 72.50 put were yielding 1.70. Mr. Meyers analyzed each of those stocks in terms of earnings and chart patterns and other criteria, and suggested selling 2 naked puts of each stated position, for a grand total of $1,100, a bit better than his $1,000 monthly income come-on. Simple calculations reveal the $1,100.
Here's the problem (there actually are two problems with the above scenario). True, one of the biggest caveats for selling naked puts is that you must want to own the underlying stock. What troubles me is that Mr. Meyers is proposing selling ITM puts. For both DLTR and ECPG, the proposed naked puts are ITM. SBUX is OTM. My own preference is to not have the stock put to me; I'd much rather just collect premium, and either buy the position to close more cheaply, or let it expire. In order to generate substantial income, one can go much further out in time and collect a far larger premium even by going deep OTM. For exam, with DLTR at $54.33 at the time of the article, the Aug14 52.50 put yields 2.00. There is significant safety in staying OTM and going further out (as of this writing, March 13, 2014, DLTR has declined to $54.21). What about ECPG? With a 200-point Dow Jones decline today, ECPG declined to $47.11, and the Jun14 45 put is going for 1.55. SBUX today is trading at $74.43, and Jul14 72.50 put yields 3.10. All these stocks are now OTM, and selling the same 2 naked puts together would yield $1,330.00 just to extend the time a bit. With a precipitous fall in the Dow Jones today, it is also likely that there might be a snap back in the next few days, thus increasing the underlying stock prices. Here, your return is higher, while your safety margin is much wider.
Let's consider our friend, Altria. At the current $36, the Jun14 35 put yields 0.93.
The second problem in Mr. Meyers' analysis is that he does not discuss margin requirement. Selling put premium is attractive (in fact, it's my favorite strategy), but in order to be approved for that, one needs to post a bond of sorts. That bond is a formula constructed by each brokerage house, but is fairly commonly assumed to be as follows: 35% of the current underlying stock price - OTM amount + premium. With our friend, MO, 35% of $36=$1,260-$100+$93=$1,253. That is the amount of money on hold to be able to sell a naked put on MO for Jun14 and receive $93. What is your return? $93/$1253=7.42% for 3 months.
'Nuff said.
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