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Educational Article

Naked Puts With a Security Blanket

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By Buzz Lynn

Afraid to sell naked puts out of fear of assignment of nearly worthless stock? I have a solution for you. It's called a bullish put credit spread and is a cousin to Jim's style of naked put trades, but does not require the potential capital outlay of stock purchases!

Veteran OIN readers who have attended OIN seminars may recall my propensity to "get naked". Jim Brown does this too and I assure you it has nothing to do with a trader's dress code. It is a strategy of selling at-the-money (ATM) or slightly out-of-the- money (OTM) calls (Deep ITM for Jim - he trades delta. Be sure to catch his on-line seminar on this very topic. It is a winner.) when a stock has bottomed and likely to rise. Naked puts (and calls) are the closest thing to "free money from God" that I have found. But they carry a boatload of risk with the potential to submarine your account (and other assets too) if you aren't careful.

Here's how a naked put works. We want theta or time decay and a rising stock price to work in our favor against the other guy. Ideally we are never put the stock and the option expires worthless to the buyer. We keep the premium for having taken the risk.

The strategy is to sell puts at the low. For instance, say that JDS Uniphase (JDSU) is trading at $180 (remember March 2000?) and appears to be on its way to $200 by expiration day. I might have sold a $180 put (ATM) for $20 in anticipation of the price continuing up (based on candlesticks, oscillators, and Bollinger bands), which hopefully would expire worthless as JDSU traded for $210 on expiration day.

Of course, as I would soon discover, I was ill-prepared for a meltdown at that time on my naked put positions. As prices of stocks began to tumble, I was in real danger of being forced to pay $180 for what is now a $20 stock (or less - remember I sold a put in what turned out to be a popped-bubble market, which allowed the holder to "put it too me" at the $180 strike price). It was either that or buy back (cover) the naked puts at a greater price for a huge loss on the position.

There had to be a better way to accomplish the same thing with less risk - time decay on the other guy with quantifiable, and minimal loss of capital if everything went wrong. That's when I began to think the credit spread might be a great strategy.

I don't know about you, but getting the benefit of time decay in my favor with only LIMITED DOWNSIDE RISK (!!) sounds like a no- brainer to me! A nice looking technical chart offering a high- odds entry is the key.

Unlike a naked position, a credit spread isn't as dangerous or intimidating as you might think. While it too carries some downside risk, it is quantifiable and you always know your maximum loss before you enter the trade. And you can use a much less volatile equity - like an index equity - instead of a volatile tech stock to make steady returns. You don't need to be a high wire expert or gunslinger to make this work. It isn't quite a "set and forget" trade, but many readers will appreciate that using this strategy does not require intraday monitoring to yield success. It can be monitored and managed once a day after hours if you like.

Here's how it works. Take for instance a biotech stock that has been bucking the trend as of late. Imclone (IMCL) finally broke out over its $50 resistance and did so on increased volume - a decent bullish sign. So with IMCL now at $53.09 and the new floor likely to be at $50, let us see how we can make some money on a credit spread.

We expect that $50 is the bottom and that IMCL will rise from here, and we want to take advantage of that. (Again, this is an example only and is not a recommendation to back up the truck.)

Just like a naked put, we SELL the JUN-50 Put for what seems like the meager sum of $1.55. But here's the twist. Just in case we are wrong, we simultaneously BUY a lower priced strike for protection - JUN45 Put for $0.50 - just in case the FDA proclaims IMCL's cure for cancer causes cancer in laboratory mice, thus sending the stock to $5 overnight with no chance for us to cover.

The net result is a credit to our account for $1.05 instead of 1.55. But we have a security blanket in the form of a long put to counter our losing short put in case of catastrophe. That little insurance policy has cost us only $0.50, but has drastically limited the downside potential. If you can squeeze the price between the bid and ask for both sides of the position, the credit can become even greater.

Just what is the downside potential? It will always be the difference in the strike prices minus the credit. In the case of IMCL, the difference in strikes is $50-$45, or $5. The credit is $1.05. The maximum loss is $3.95. Of course, all of this is per share.

Per contract, that means a profit potential of $105 with a maximum loss of $395. $395 per contract also happens to be the margin requirement since it is the most you can lose. $105 return divided by $395 of margin sounds pretty good to me - that is 26.5% on your margin capital in just two weeks! You can do this spread for as many contracts as you like, as long there is an equal amount of both positions. That way your short position always stays hedged with your long position.

Entering the trade is pretty simple. First, you must be approved for spread trading with your broker. Many on-line brokers actually let you enter the whole position from their interface so you do not have to leg in one position at a time. Unfortunately, Preferred does not have that capability (yet) so the order must be phoned in, and they will only accept orders of 10 contracts or more. Fortunately in this example, 10 contracts requires only $3950 in cash or marginable securities for the $1050 profit potential, a figure manageable for many accounts. You do not already have to be rich to pull this one off!

The $1.05 credit is ours to keep if IMCL is above $50 on expiration day, June 15th. Breakeven occurs at $48.95. That occurs if we are put the shares at $50, but have the $1.05 credit against it for a cost of $48.95. Anything less than that at expiration, and the position goes in the red a penny for every cent under $48.95 all the way to maximum loss of $3.95 per share. Remember though, we were smart enough to have bought the $45 put that saves us from further loss even if the stock price goes to zero! That is our security blanket!

Naturally, we ought to try to limit losses. Thus, it may be in our best interest to buy back the whole position for a cost of less than $3.95 if the trade gets too far away from us and reaches our threshold of financial pain. Each of us must make that determination for ourselves. Personally, unless there is a technical reason to stay in the play with the idea that it will soon be profitable again, my preference is to close the whole position when the stock price trades at less than my breakeven ($48.95 in this case). It is an arbitrary figure that I use to tell me the play has gone south beyond my expectation and that I should exit now to avoid maximum loss upon expiration.

One other thing. While it does not always happen, if we let a position get too far away from us by hanging on too long, a position can cost more to close than the loss we would take on expiration. In that case, I will let the contracts expire for maximum loss. But if I do that, it will always be a painful reminder that I should have sold too soon. Don't let the trade get away from you like that.

Back to the big picture. . .our intention here again is to have time decay work in our favor to narrow the spread to zero by expiration and the whole $1.05 will be ours! Ten contracts of this trade would ideally yield $1050 if held to expiration for maximum profit and we would only need to maintain $3950 of margin to do it. (Check with your broker as most require a minimum account size to employ this strategy - Preferred requires $10,000 in cash balance).

Now can you see the profit potential? Again, the key is time decay working in your favor. But with a credit spread, your downside risk is limited and quantifiable. You'll sleep much better at night employing this strategy rather than "getting naked" and worrying about "accounting irregularities" on the company in which you shorted puts.

Now you too can get naked with a security blanket!

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