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Going Naked for Fun and Profit

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Going Naked for Fun and Profit
By Jim Brown

No, this is not a column on streaking. What I am talking about is way more fun and much more profitable. I am talking about selling naked puts. Not just any naked puts but Deep In The Money on aggressive stocks. This is the closest thing you can get to free money in my opinion. Bear with me and read the entire article before making any judgments.

The basic naked put concept involves finding a stock that is moving up with a good trend. The basic Naked Put section of the newsletter is probably the most profitable and most consistent section we have. The plays that Ray and Mark pick each week are very safe, if there is any safety in this market, and average 10%-15% profit per month. Multiply that by 12 months and you get a very nice living. The only qualifier is you must have naked option writing capability or spread trading capability in your account.

Using the example below you can see the basic strategy in action. There are two different ways to use this.

The first strategy would be the very conservative strategy of selling a $60 put on a $80 stock. Your margin requirement is 25% of the $80 or $20. The premium you receive for selling the put is $2.63. This makes your return for the very conservative strategy of 13%. ($2.63/$20=13%) Your risk is that the stock will decline to less than $60 and the stock will be put to you. This is less risk than selling covered calls. You do not own the stock. It can drop -$20 before you are at risk. Your breakeven is $57.38 ($60-2.63) Very safe, very repeatable.

The conservative strategy using the same stock is to sell the $70 put for $6.13 and this increases your return to 30.6% because the margin did not change. You still have a $20 margin to make $6.13. ($6.13/$20 = 30.6%) Your risk is now that the stock will drop under $70 and the stock will be put to you at $70. Considering your premium of $6.13 your breakeven is $63.88. If the stock closes at any price over $63.88 on expiration Friday you are profitable.

The key to the basic strategies is selling puts under strong support levels. These support levels protect you to some extent from falling prices and market events. You should also use stop losses to take you out of the trade if the option price rises more than +25% over your sales price. This means the stock is falling and your risk is approaching. You can always wait for the stock to bounce and sell another strike to recover your stopped out price. This is very easy to do.

Aggressive strategy:

This is one of my most requested classes at our seminars. I use a Deep In The Money strategy for selling naked puts that maximizes returns by fully utilizing the high delta of in the money options.

Consider this example:

The stock is at $225 and the three strikes available are $220, $230 and $240. The premium for the $240 strike is $45.38. The margin for the trade is $56 or 25% of the stock price. If you sold this put and it expired worthless you would have an 81% return. ($45.38/$56 = 81%) This equates to an 81% return for a $16 move.

The reason for the big returns is the difference in Margin and the high premiums from being deep in the money. It requires the stock to move up from where you sold the put but relatively speaking they do not have to move far to increase the returns.

Consider the chart above. The premium you receive for the difference between the strike price and the stock price is Intrinsic value. Or stock value. This is exactly like a call that is $40 ITM. Every dollar the stock goes up you get almost $1 in premium increase. If the stock goes down you get almost a $1 decrease in the value of that call.

Same with the Put. For every dollar above the stock price you sell a put it is "in the money" and the value is totally intrinsic. Every dollar that stock moves up reduces the value of your put and increases your profits. Once the stock price passes the strike price the premium decays slower because it is all time value.

Consider this, if you sold a $250 put on a $100 stock how much would the stock have to go up for you to make money?

Using this example and assuming the put premium was $175 for a $250 put on a $100 stock the stock would not have to move at all for you to be profitable. The time value would decay and you would have to give back the premium you did not use or $150. In reality you would sell a current month put with little or no time value but ANY movement over $100 would be a $1 for $1 profit for you. If the stock finished anywhere between $100 and $250 you would be profitable. The margin on this trade is $25 to start, (it is 25% of the stock price and will go up as the stock goes up). If your margin was $25 and the premium was $175 your return would be 600%. This would be extreme and I am only using it as an example. Still it is factual.

Now, using this example, if you sold a put $100 over the current stock price of any stock that was moving up, would you care where the stock finished the month? Your only care is that it does not go below the price it was when you sold it. That means if you sold a $250 put on a $100 stock you should close the trade if the stock moves under $100. That puts you at risk for being put the stock or having to buy back the put at a higher price.

If you sell a naked put on a stock that is moving up and then set your stop loss at a dollar or two below the stock price where you started the play then your loss will be that dollar or two that is not covered by your stop loss. Once your put is profitable you can move up your stop and then be stopped out for a profit if the trade goes against you. Normally you are only at risk during the first two days of the play. If you sell on a serious dip then you have to have a more serious dip to cause you problems.

The drawback of course is you must be able to own this stock unexpectedly. An after hours drop can cause the put holder to exercise your put and you will own the stock. As long as you close the play whenever it drops below the opening price you should almost never see this problem.

A major drawback to this strategy in this market is the gap down on the open on negative news. Everything is fine the day before but somebody warns and the entire sector drops -$20 before the open the next day. The way to protect against this is to buy an "insurance put". If you are selling $50 ITM on the upside and taking in a $55 premium then before the day is over go about $20 OTM or under the stock price and buy a put. The price that far out of the money is normally $4-$8 depending on the volatility of the stock. Now if you get a gap down your naked put increases in value but so does your protective put. You will not get a $1 to $1 move in each but you protect yourself against more than a $3-$5 loss. You are effectively turning the play into a spread and limiting your maximum risk.

If this strategy interests you I suggest you go look at some charts for some fast moving stocks. Pick a strike price $30 to $50 away from the stock price and do the math on the margin and premium. You will be amazed at the return possibilities.

Fine tuning this strategy.

First, you do not want to hold the plays to expiration. I like to sell $50 to $100 DITM and then close them after a run of $20 to $30. Take your profits after any 3-5 day run. Nothing goes up forever and the longer you are in a play the greater the possibility of a drop in the stock.

Repeat the play on another stock. You can normally do this about three times per month. You wait for a dip in the market and stock, sell the put, wait 3-5 days and close the play. Then wait for the next market/stock dip and repeat. It does not have to be the same stock. There are hundreds of choices. You can vary this strategy and use less volatile stocks, nice steady growers. You still get $1 for $1 profits and your margin is only 25% not 50% like buying the stock.

We publish a list of high premium, high volatility stocks in the newsletter each week for this strategy. Find the list and paper trade several for a week or two and you will see why I like this strategy better than any other.

Jim Brown

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