As part of our ongoing renovation for all the Option Investor family of newsletters I am changing the direction and methodology of the Option Writer publication. There will be two different strategies in use. One will focus on high return speculation by writing in the money puts while the other strategy will concentrate on writing out of the money puts for monthly cash flow.
While I love writing naked puts I avoid writing naked calls. Put writing does have risk but the risk is contained. Writing naked calls exposes the trader to unlimited risk. Much of the risk on both sides can be reduced by using stop losses BUT normally when an unexpected move occurs it is normally accompanied by a large gap open that makes stop losses useless. The risk is normally greater for an upside event although major decline do happen on negative news. The difference in risk is evident by the difference in margin requirements for writing naked puts compared to naked calls.
New positions will typically be sold naked but occasionally we will create a put spread to reduce risk and margin requirements.
I want to remind everyone that writing a $20 put on a $25 stock has exactly the same risk as writing a $50 put on that same $25 stock. That example is extreme but I am using it to make a point. If you write a $25 put for $1 on a $25 stock and the stock gaps down to $20 your risk is $4 if that occurs on the day before expiration. (The $20 stock is put to you at $25 less the $1 premium you received.) If you write a $50 put for $26 and the same gap down to $20 occurs your risk is still $4. (The $20 stock is put to you at $50 -$26 in premium + $20 stock) The risk is exactly the same.
However the reward is drastically different. The most you can make on the $25 put is $1. The most you can make on the $50 put is $26 (premium received in both cases). If the risk is the same then why would you want to write the $25 put?
Not all plays are going to be deep in the money puts but there will be a few in the speculative portfolio. I know this strategy strikes panic in the hearts of conservative investors so the other strategy will be the conservative out of the money puts for cash flow.
There will be two separate portfolios and two separate watch lists. There will also be plays initiated that are not on the watch list if a news event produces an entry point. An example would be a major drop in a stock due to a news event that is not terminal. The knee jerk drops typically raise volatility significantly and in many cases the initial drop is the worst case and investors use the drop for a buying opportunity. We will use it for a selling opportunity for puts.
I am only recommending one put this weekend because I am concerned about the potential for a market decline over the summer months. We have seen a major rally from the March lows and while I think the long-term trend will still be higher I am concerned that the normal dog days of summer will allow stocks to cool off before an economic recovery rally takes them higher.
Since tech stocks normally have higher volatility associated with their options they do make great candidates for put writing. However, we are entering the four worst months historically for the Nasdaq so writing puts on tech stocks over the summer is not normally a wise game plan.
Because I have a personal bias towards energy stocks there will be some energy plays but I am not going to favor energy above all else unless the technicals make sense. Any sector is fair game as is any stock.
The initial recommendation will be conservative using MCSI Inc (Nyse:MXB). Their business model is market neutral and they have a steady uptrend in progress.
MSCI Inc. (MSCI) is a provider of investment decision support tools, including indices and portfolio risk and performance analytics for use by institutions in managing equity, fixed income and multi-asset class portfolios. The Company's principal products are its international equity indices marketed under the MSCI brand and its equity portfolio analytics marketed under the Barra brand. Its products are used in many areas of the investment process, including portfolio construction and optimization, performance benchmarking and attribution, risk management and analysis, index-linked investment product creation, asset allocation, investment manager selection and investment research. The Company's primary products consist of equity indices, equity portfolio analytics and multi-asset class portfolio analytics. As of November 30, 2008, the Company had over 3,100 clients across 64 countries.
Recommended Position with MXB = $24.74
Sell August $22.50 PUT MXB-TX currently $.80
Stop loss $22.00
Chart of MXB
There are several different formulas for determining margin requirements for naked put writing. These are normally broker specific and some can require larger margin requirements than others.
Here is the most common margin calculation for naked puts.
100% of the option premium + ((20% of the Underlying Market Value) - (OTM Value))
For simplicity of calculation simply use 20% of the underlying stock price and you will always be safe. ($25 stock * 20% = $5 margin)