Selling naked puts, otherwise known as cash secured puts, is a higher risk strategy for larger accounts but not nearly as high risk as selling naked (short) calls.

Cash secured puts is a BULLISH strategy for BULLISH stocks in a BULL market! It is not a strategy for down trending markets or markets with serious chop. When writing naked puts on a stock you never want that stock to fall below the price it was when you wrote the puts. It can happen and you can still be profitable but it is a good rule of thumb to try and follow that plan.

Investors who feel that a particular stock will rise have two types of basic option strategies that they can use, buying calls or selling puts. This is by no means all the strategies available but the most commonly used.

When buying calls the investor must deal with premium decay. The decay works against you and must be overcome by aggressive movement of the underlying stock for the position to be fully profitable.

The "delta" of an out of the money call can be as little as .50 ($.50 move for every $1.00 change in stock price) or even less for deep out of the money calls.

Using the Nike example below at $132, the January $135 call and $130 put were trading for the same premium of $5.

The long call investor will pay $5 for the privilege of capturing any stock appreciation above $135. Actually in order for them to be profitable at expiration the stock must trade above $140. ($135 strike plus the cost of the premium $5) We all know that we do not have to wait until expiration to sell the call and we could achieve a profit if the stock jumped significantly anytime between now and expiration. I am using the price at expiration because it makes it much more understandable. The point I am trying to make is that should the stock falter, slow down or go flat the premium paid will decay against me. That means I cannot get back what I paid for it in most cases.

If I sold the January $135 put for $5, my risk is that the stock will drop below $130 before expiration. Any number above $130 represents a profit for me where the call buyer must see the stock rise and rise sharply to be sure of a profit. I benefit because I received $5 in premium for the put rather than spend $5 for the call.

If the stock did nothing and closed exactly at $132 on expiration Friday I would not be put the stock at $130 and I would reap a full $5 profit on the trade. Time premium decayed in my favor.

The Downside

One of the downsides is the amount of money required to initiate the play. With most brokers it requires a margin account and a minimum of 20% of the underlying stock in margin. Assuming Nike at $132 and one put contract that would be $2600 compared to $500 to initiate the call.

The biggest downside that scares most potential put writers is the risk of assignment. With ANY naked put position you are subject to assignment on any given day. Even if the stock has risen $20 from the price at which you wrote the put you can still be assigned. It is a random process and handled by the Options Clearing Corp whenever someone exercises their put option. If you sold an $80 put when the stock was at $60 and the position remained open for a month you could be exercised by someone who bought an $80 put just a day or two before, in order to protect against their stock dropping. You may have sold yours premium for $20 and they may have only paid $2 due to the change in stock price and the time involved. Once in the hands of the OCC they are all the same and you can be assigned at any time. For instance, the stock may have risen from $60 to $78 but someone could put it to you at $80 for any time.

For instance, using round numbers you sold an $80 put on a $60 stock. Two months pass and the stock has risen to $78 and you get assigned. You are assigned for $80 and you immediately sell the stock for $78 for a $2 loss. You sold the premium for $20 and you have a $2 debit to your account. Your profit is $20 - $2 = $18 profit per share. That is a really nice gain.

The another downside to the naked put strategy is risk. A call buyer only risks the $5 premium paid for the call. A put seller is at risk that the stock could fall below his breakeven point, which would be $125 in the example below. (Strike price $130 minus the premium received of $5)

The put seller can protect himself in most instances with a stop loss based on the stock price. It is however still possible to lose money since stocks could gap down on very bad news below your stop loss. Assume Nike announced very bad earnings after the close. The next morning it opens for trading at $120, well below your strike price and below your stop loss. You would then be at risk for the difference between $130 and $120 (breakeven) or $5 per share. ($10 premium increase to $120 less the $5 initial premium sold or a $5 loss.) While this is not a normal course of events for most stocks it does happen occasionally. Most gap downs are in the neighborhood of $3-$5 but occasionally you get a real disaster.

To protect against disasters most investors choose to write deep out of the money naked puts. The concept here is that they are so far out of the money they have little chance of being put. They pick a point below distant support and take a profit writing front month puts each month.

Using the Nike chart as an example of conventional put selling would be the December $125 strike put for $2.50. This produces about 9% yield. ($2.50 / $26.00 = 9%) This is a pretty good return and can be easily done each month in a bull market.

The down side to this strategy is the same as the more aggressive of naked puts. Should Nike gap down to $125 on bad news you are still out the difference between your strike of $130 and the $125 stock price minus any premium received. This calculates like this. $130 - $125 + $2.50 = $2.50 loss.

If you chose the ATM play as your option then let's follow that concept a little farther. Let's look at the deep in the money options.

Deep In The Money Naked Puts

This is my favorite subject. I have written hundreds of pages on this topic and taught it to thousands of seminar attendees. I love to play DITM naked puts.

The concept is the same as conventional naked puts only carried to a higher level. Remember, writing naked puts is a bullish strategy for bullish stocks in bull markets. There are exceptions to the rule but generally the guideline above should be followed.

What is a deep in the money naked put? Generally it is a put with a strike price several strikes higher than the current stock price. Using the Nike at $132 example a January $150 strike price would qualify as deep in the money with an $20 premium.

The first question I usually get is why don't you get put the stock the very next day after writing the put.

Multiple Answers:

First, the market makers have to "make a market" that means they have to maintain a bid/ask for every strike that is offered. If they arbitrarily closed every contract that was opened then they could be fined or censured for failing to make a market. That is a thin line but it keeps most of them honest.

Second, if you write puts extremely deep in the money then the chances are much greater that you will be put. The premium received comes out of the market makers account and he would rather get the interest instead of you. This still does not prevent the strategy from working, it just makes picking strikes a little more difficult.

Third, just because you wrote something $20-$50 deep in the money does not mean the market maker can just put you the stock for a profit. Remember this is a profit deal. He will not put you the stock just to clear his books. He will only put you the stock if he can make a profit or break even on the transaction.

Let's follow some examples.

Assume Nike at $130 in October. Assume the December $150 strike is $22. Let's keep it even numbers for discussion purposes. Notice there is a minimum time premium of $2 in the January deep in the money put options. Assume you sold the $150 put at the open during the heat of a rally for $22. You sold ten contracts or less at market. This means nobody got to see your order. It was executed by computer and "assigned" to the market maker as routed by your broker. The market is in rally mode and Nike closes at $132 with a $2 gain on the day. The $150 put has now declined to $20.

The market maker is faced with putting you stock, which costs him $132 at the close and receiving $150 back for it. He is getting $16 back for the $20 he gave you earlier that day. Premium of $22 declined to $20. How long will he stay in business doing that? If he puts the stock to you at the close he loses $4 per share.

Before you start pointing out the obvious errors in the above scenario rest assured that this happens more often than not. Yes, some brokers would have immediately "covered" when they got the notice of assignment. They do this in many ways by purchasing stock or creating different types of spreads to offset their risk. They function under entirely different margin requirements than retail customers and can leverage themselves 20-50 times higher than we can. This means they can take a stock/option position to cover the trade for pennies on the dollar. This also means they will not normally close the trade for a $4 loss.

There are market makers that will cover and close every naked put that is $20 out of the money at the instant it is written. There are others that never close any. They just cover their risk and continue with business. I have written millions of dollars of naked puts, some over $100 deep in the money back during the rally in 2000, and was very rarely assigned if I triggered the transaction correctly. More on this later.

Why Deep In The Money Naked Puts?

If the stock you are following is showing a positive trend there are many reasons to use a deep naked put instead of a call. I touched on the premium decay above and why it works against you with a call. The delta of a call is significantly worse than the delta of a deep put.

As the stock price moves up the premium of a deep put drops by almost $1 for every $1 the stock price rises. This is because the delta is nearly 1.00. Where the call premium may only be increasing $.30 to $.50 cents per dollar the put is decreasing by $1.00. This is maximum delta.

Let's look another graphic. The chart below shows an extreme example to help get the point across.

Assume you sold a $250 naked put for $150 premium on a stock that was only $100 at the time you wrote the put. Where would you be profitable in this example?

You would be profitable at any point over $100. $110, $175, $210, $105, $150 or any other amount over $100.

This is only an example but you can see the difference between the at the money put and a deep in the money put. A $100 at the money put for $5.00 would be fully profitable at $101 and would never increase in value regardless of where the stock finished above that number.

If the stock gained another $100 your $100 put for $5 would only produce $5 in profit. The $250 put would gain at least $100 in additional profit.

The Catch.

The catch is that ALL the options have EXACTLY the same risk. That risk is the stock falling below $100.

What is the risk for the put writer for each of the naked put options shown in this example? ALL the strikes have exactly the same risk and that is a decline below $132, which would be the price when the options were written. For each strike the premium received would be almost exactly the difference between $132 and the strike price. I rounded them in the example for simplicity.

I get questioned constantly why a buyer of a $150 put in this scenario would not simply put me the stock for $150 when it is only worth $132. Most people think that this is the risk I take when writing naked puts.

This is far from the truth. In reality the risk on each of the puts listed above is exactly the same. In this example for every dollar of stock increase the premiums will decrease by almost $1. The $135, $140, $145, $150 strikes will decline by $1 for every dollar Nike rises. In every case it will be almost a one-to-one relationship.

The same is true with the risk side. If the stock drops from the current $132+ level then the put premiums increase one-to-one for every dollar the stock drops. So the ONLY risk an option writer has is for the stock to drop below the price it was when he wrote the put.

If the premium (and I am going to use round numbers for this example) received for writing a $140 put on a $130 stock was $10 then I make $1 for every dollar the stock goes up and I lose $1 for every dollar the stock goes down. Without factoring in any time value on EITHER direction I can easily see that a decline to $125 stock costs me $5 since the put premium will increased by $5. The premium is the difference between the stock price and the strike price. (Remember we are not factoring in time value since deep in the money puts typically have zero time value)

In the figure below I have illustrated the profit and loss areas for five different puts ranging from $80 to $120.

Notice that I only lose money if the stock goes down.

I lose exactly the same amount regardless of whether the stock is a $80 or $120 put. However should the stock go up my profit is capped on the lower strike prices. I can only capture as profit the difference between the stock price when the put was written and the strike price. It does not make any difference if the stock goes up $15 or $150 if I only wrote the $80 put. I can only make $10.

If I wrote the $120 put my risk is exactly the same but I can make $50 in profit if the stock rises over $120.

The risk/reward ratio for this type of play is very generous. Assuming your account is at a friendly broker the margin required to write a naked put is between 15% and 25% of the underlying stock price plus the actual premium you received. This equates to $1750 (at 25%) per contract on a $70 stock.

Assuming your risk is the same for any in-the-money naked put your risk/reward ratios would look like this using the maximum margin rate.

Now before you start slobbering all over the page I will be the first to tell you that you should never get those returns. The odds of picking a stock, writing a $50 in-the-money put and having the stock move over $50 in your direction before you decide to take a profit is very slim.

I would highly recommend against planning for that type of trade. You are simply setting yourself up to fail.

Now, having said that I will tell you that it is possible with leap puts.

Winning Strategy

If you have an account with naked writing privileges, I think this is the best strategy available. You do not have to be concerned with premium decay as in call options. You bring money into your account, which will draw interest while the play is in progress. You can repeat this strategy every month for solid gains IN A RISING MARKET. This is not a strategy for a bearish or choppy market. This is how I would do it.

Find a stock that is trending upward with good volume in the put options.

Exact instructions:

1. Pick a stock with a strong uptrend and preferably a fast mover.

2. Wait for a pull back to support, the bottom of a trend channel or just a major market event that knocks all stocks back into the prior week's price range.

3. Once the rebound begins, sell a put at least $20 above the current stock price. This insures that there is little or zero time value and the delta will be almost 100%.

4. Set a stop based on the stock price at about $3-$5 below the stock price where you sold the put. If you were aggressive and tried to pick the bottom exactly then set the stop loss about $2 under the bottom.

5. Once the stock has moved up $3-$5 move your stop loss to exactly where the stock price was when you sold the put. This prevents you from losing any money but does not get so close to the stock price that you get taken out on the very next dip.

6. Once the stock has moved up another $2-$3 ($5-$7 from where you sold the put) start trailing the stop loss behind the rising stock price. Keep it $3-$4 under the price or $1 below the priors days low.

7. After you have been in the play several days/weeks and the stock has been moving up gradually, look for a spike day. Shorts will decide that the pain is too great and cover or new investors will decide the stock is running away from them and panic buy. Either of these presents an opportunity to exit.

If you are watching your stock closely, as you should be, you will notice this jump in price above the normal give and take. This is the time to cover. Either close the position or start moving the stop up to within $2 of the current stock price and let the next dip take you out automatically. Either way, take the profit and get out.

8. Now wait. Wait for the next rotation downward on profit taking. This happens after the panic buyers dry up and the pressure from shorts covering evaporates. The stock will NORMALLY drop back between $5-$7 on any 2-3 day profit taking event. Wait for it to bounce off support. If it does not bounce then it was not support.

9. Confirm the bounce. If your support line was $120 and the stock bounced exactly on $120 you still want to wait a day or so for positive movement before opening a new position. Everyone else may have thought $120 was support also and that is where the buy orders were entered. If there are still sellers in the stock the bounce will fail within an hour or two. Confirm the bounce! Pigs get fat, hogs get slaughtered!

10. Repeat steps 2 through 9.

Ideally, you would like to capture a $5-$7 profit on every cycle. If you are selling deep enough in the money (about $20) then it should not be a problem to make $5-$7 on a $7-$8 move. Most stocks will have a profit taking cycle every $7-$10 of positive movement. Some more, some less.

Normally there are 4-5 profit cycles in every three-month period. If you only made $5 on each cycle that would have been $20-$25 and the stock only rose $30 in that same period. This is the beauty of cycle trading in naked puts.

Market gifts

From time to time there are events that rate as gifts from the market for naked put traders. In reality, it does not make any difference what craters the markets. In any given year there are 2-3 serious drops from things like geopolitical events, major earnings events or just simple corrections. If you are invested before these events I have never seen anyone rush to your aid and refund your losses. It is just life and as investors we need to realize this. When these events occur we need to be ready to jump into the abyss and sell those deep in the money puts when the rebound begins. If you only traded these significant market events and sold puts 2-4 months out instead of front months this is the only strategy you would ever need.

The recent August drop above was extreme but so was the rebound. The harder they fall the more profitable the rebound. Again, sell the rebound not the dip. We do not want to try and catch falling knives.

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Jim Brown

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