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Naked Put Writing And The “Big Hurt”.

Posted by Pete Stolcers on June 20, 2006

Option Trading Question

Today Tom T. states, “I have been selling puts as a means to generate income for about 18 months. Most months, I have made money, but in the months I have lost money, I have lost big - even though I try to limit losses by buying back puts when the price of the underlying stock drops below a pre-determined level. In my losing months, there are usually a small number of stocks that drop very quickly (this past month was brutal) and these small-in-number/large-in-value losses wipe out my large-in-number/small-in-value gains. Please help.”

Option Trading Answer

Tom’s situation is not uncommon. In general, selling strategies tend to be consistent with many small winners and a few big losers. Premium buying strategies tend to have many losers, but a few really big winners. Here are a few considerations that might help.

The first take-away from your comments is that you are a “one trick pony”. You are only using one strategy - put selling. There is not a one size fits all strategy that works all of the time. The problem with put selling is that you are always bullish and you only see one side of the market. The only way you can be bearish is to be in cash. You must be mindful of the overall conditions. Over the last year implied volatilities (IV’s) have been at historic lows and you were not properly compensated for the risks you took. Premium buying strategies were actually more efficient from a risk/reward standpoint (provided that you used the same number of contracts).

The second concern is that you tried to buy-in the puts and still you were taking large losses. This tells me you were exposed to big moves (gaps). When you are selling puts, it is imperative to do extensive research on the underlying both technically and fundamentally. Technically the stock should be above long-term support and it should be in a long-term up trend. The puts should be sold below that support so that you have time (even if it is momentary) to buy them in when the stock rests there. Fundamentally, you must know the company because you are in essence long the stock past a certain point. You have to know when the earnings are “due”. I usually like to sell puts after the earnings are out even if it means missing some gains. If the IV’s are high in the stock, an extreme amount of caution must be used. The “rich” premiums are not there by mistake, something is about to happen.

The third issue deals with the fact that you are buying in the puts. When I sell puts I have drawn a line in the sand and I have stated, “I hope I get a chance to buy this stock at this level.” I put half of the strike price in reserve and I plan on buying the shares. It puts me in a different mind set. In these cases I need to know the company. If the stock has broken down because of a material change, I must buy in my puts. If the stock has drifted lower because of a market move, this strategy forces me to “buy low”. Do I have to take assignment on all the positions I sell puts on? No, but I should have a firm enough conviction to buy most of them. The other possibility is that you don’t have the capital to buy the shares and that is why you are buying in the puts. In that case, you are over-leveraged and “scared money never wins”. Very often, you will see a stock dip below the strike near expiration, you buy in the put and you are left holding the bag as the stock takes off. I’m not advocating taking huge losses or marrying a stock, but there are times when you have to trust your research and take a some heat.

Put writing is a great strategy, but it has its place. I have found it to be most effective when the market has sold off (like now), the fear is high (relatively rich IV’s) and the “baby has been thrown out with the bath water” (good companies have been sold off in sympathy). I like to scale into positions. I assume that I have not picked a bottom and I will probably have a chance to sell more puts at higher prices. Scaling in also helps me keep my emotions in check if the initial positions move against me. I know that if the market finds support, these prices won’t be there long and I have to at least start a small position. The bottom line is that I want to own the stock and I view this as a stock buying strategy with a “cushion”. At an extreme, this tactic might comprise 40% of my portfolio under the right conditions.

If you have had a similar experience or you have a unique approach to put writing, please share it.

Option Trading Comments

  • On 02/28, julian said:

    do you have to wait for expiration, in order to complete the trade. (selling put) or can you just buy back (to close) at anytime?
    thank you.

  • On 02/28, Pete Stolcers said:

    Hi Julian,

    You can buy the option back at anytime. I usually place a stop at the strike price for the short put. That keeps me from getting assigned.

  • On 12/24, Jay said:

    Hello,

    If I write a PUT with say 6 months to expiration and it gets ITM in the current month, can I be assigned anytime i.e the current month or assignment occours only during the expiry month?

    Thanks
    Jay

  • On 12/28, Pete Stolcers said:

    You can be assigned months before expiration. It is fairly rare, but if the option is deep in the money and the option is not carrying any premium (trading at parity), you can be assigned.

  • On 01/04, Nick said:

    Also, I believe a good potential alternative strategy is to take delivery of the stock if the trade goes against you and then immediately start selling covered calls to continue to generate income, assuming that is your motive.

  • On 01/08, Pete Stolcers said:

    That is a good approach as long as the stock has not broken major support levels and the fundamentals are still intact.

  • On 01/08, Nick said:

    great point Pete, thanks!

  • On 01/22, gary said:

    Hi,

    I was thinking about exactly what Nick said”...take delivery of the stock if the trade goes against you and then immediately start selling covered calls...”

    Let’s say the stock is at 15, and you sell a put at 10. The stock drops to 10 and you actually want to buy it right then (it might be at the support level and you anticipate a move up). How can you take delivery of the stock before the option expires? Especially if the option has alot of intrinsic value left?

    Is there a way to automatically take delivery and get out of the put obligation at the strike price you sold the put for?

    thx!

  • On 01/23, Pete Stolcers said:

    That’s a great question. Unfortunately, the answer is no. As an option seller, you are powerless. The option buyer holds all the cards and dictates the terms. There are times when you want assignment because you want to sell rich calls against the stock. You can’t sell calls against your naked put because the call is considered naked since you don’t own the stock. Most traders can’t get approved for naked call writing. Secondly, if the stock rocketed and you did not own it, your risk is unlimited. The short put position will only protect you for the first part of the move.

    If you want to sell calls against an ITM put position, you might consider a call credit spread.

  • On 08/23, Charles said:

    When you sell a put you have a choice on which strike to sell.  Generally, you should only be selling puts when you are convinced the underlying is moving up.  If true, then you are bullish and I claim its best to sell ITM puts.  When you do so, your delta is higher and the potential gain is much higher—all that intrinsic value can be yours and, hey, you get it paid all up front.  So even if the stock moves down, you can simply apply that intrinsic value already paid to you (plus the extrinsic value you got) toward the purchase of the stock.

    Even if your position stays ITM as you approach expiration, you can usually avoid assignment by simply monitoring the remaining time value and, if it gets close to zero, buy back the put and sell another one further out for additional time value.  As long as the stock doesn’t tank, you can keep doing this until your put finally expires worthless (OTM) or you decide to move to another underlying.  Each time you roll, you will be getting more time value.

    Now, you may well have to book a loss on each roll if the stock is going down, but if you are still convinced that it will eventually recover, you will get those losses back plus all the time values you sold along the way.  You may also choose to sell additional puts at a lower strike as the stock moves down to help cover your losses and to “average down” your position and bring in additional time value.

    Of course, you cannot sell too deep ITM else you will not have much time value, and you need a fair amount of time value to avoid being assigned too soon.  I would say one strike ITM is usually a good place to be.

    Another benefit of this approach is that the margin requirements (at least with e-trade) are only 20% of the strike price, so you can leverage up quite a bit without testing your margin limits and, best of all, you are being PAID interest on the cash you take in rather than paying interest on your margin balance.  Before I learned this approach, I was paying more than $20/day interest on my margin balance.  Now I get paid to maintain a much larger margin balance.

  • On 01/18, Glen said:

    Think of yourself as a little insurance company.Write low risk puts at a strike price below support on good companies.I
    ndeed, write on companies where -if put-the dividend would be substantial.Given your premiums will be lower-but you will rarely be put.
    If the expiration date nears and you are near or in the money, roll laterally to the next month.Don`t be averse to buying(closing) in your put positions at a good profit.
    Your margin for the puts should be comprised of steady high dividend stocks or reliable bonds.At the most conservative,you can at least use cds as the margin.
    If the nightmare scenario occurs-dramatic violent price drops as in November of 08 or 1987- what happens?Given that you keep plenty of margin collateral around-you`ll be fine.You`ll simply end up owning a great company from which you`ll collect dividends and write calls on.
    Follow the above approach and ,over time, you will consistently beat most mutual funds and many hedge funds.Like other well managed insurance enterprises, you will flourish.

  • On 01/19, Pete Stolcers said:

    This is a consistent approach. The key is to pick good stocks and to make sure you have enough reserve to buy the stock if you are assigned. If a material news item changes the character of the stock, you might need to take your lumps and remove it from your list of put writes.

  • On 05/11, jayme pereira nunes said:

    hello pete, I have a question and I didnt know in which topic it would fit better, but I believe, since this one has to do with naked puts it will fit perfectly.

    I recently started in options, and I must admit I havent read as much as I should, and I am afraid I made a big mistake, here is my case;

    I sold 100 puts of ABK with a strike price of 2 and a premium of .60, as you might have already realized, I got the credit of 6.000 dollars in my account.

    now I would like to close my position (buy to close) the stock is currently trading at 1.40s - its important to mention that *I DO HAVE THE AMOUNT IN MY ACCOUNT TO BUY TO CLOSE* (so even though I am uncovered its not margin)

    so, if I buy to close, I will have to buy 100 contracts (10.000 shares) of ABK , right ? that will give 20.000 dollars (ok, I do have this amount in my account) my questions are as follow;

    1- If I decide to buy to close, am I going to take a loss of 14.000 USD ? (20.000 minus 6.000 from the premium I got)

    2- if so, is there any strategy you would advise to avoid/minimize the loss ?

    3- I thought since I would be buying to close, I would be buying back or buy those 100 contracts/10.000 shares at 2.00(my put strike price) and then I could sell them at the current market price or hold them and try to sell in the future, apparently I was wrong right ?

    4- If I try to let them expire, but by then someone executes me, I have to buy those 10.000 shares at 2.00 and deliver right ? does that mean I also take a loss of 14.000 USD, isnt it ?

    thanks in advance,

    jayme

  • On 05/13, Pete Stolcers said:

    When you sell a nake put you are committed to buying the stock at the strike price. You can factor in the premium received to calculate your ture cost per share. In your case, If you sold the $2.00 puts for $.60, you actual cost basis for the stock is $1.40($2.00 - $.60). If you can afford to take assignment, you will own the stock for $1.40. Where you eventually sell the stock will determine your profit or loss. If it is above $1.40, you will make money on the trade.

    If you choose to buy back the puts, you can. Anything over $.60 represents a loss on the trade.

    This is a VERY risk stock to start with. High implied volatility does not mean some idiot mispriced the options. It means that uncertainty surrounds the stock. You should consider starting with something more predictable.

  • On 07/22, Bob said:

    Can you write a put option and collect the
    premium on a strike price that is greater
    that the price of the stock ?

  • On 07/26, Pete Stolcers said:

    Yes. The position becomes more of a speculative long because you need the stock to rally to avoid assignment.

  • On 07/23, jb said:

    Hi Peter:

    When selling puts naked...What is the standard margin requirements and or does it vary from b/d to b/d...and my real question is how does selling puts effect the buying power in your account?

    For instance say i have portfolio of 600k and i have buying power of another $300k that i rely on to trade. As a way to add income into the account i want to start selling puts. How will that effect the buying power of the account once the premiums are credited. for example:

    naked:
    Sell 100 Jan 13 10 Puts @ 3.50 = $35000 credit...stock is at 7.50

    After the 35k is credited to the account how will the buying power be effected?

  • On 07/25, Charles said:

    @JB:  I suspect the margin requirements vary from broker to broker and, to be honest, I don’t fully comprehend my broker’s margin requirements for naked puts, but I believe the rule is 500% of marginable securities.  I assume this means I can take on a liability of $500,000 for every $100,000 in cash where liability is 100*NumberOfContracts*StrikePrice.  I rarely exceed 200% and I keep pure cash rather than stocks for my marginable securities.

  • On 07/25, Pete Stolcers said:

    The margin requirements do vary from firm to firm. They can’t be lower than the exchange minimum which is:

    100% of option proceeds plus 20% of underlying security / index value less out of-the-money amount, if any, to a minimum for calls of option proceeds plus 10% of the underlying security / index value, and a minimum for puts of option proceeds plus 10% of the putís exercise price.

    In your example, you will have to put up .20 x $7.50 x 100 contracts x 100 (option multiplier) = $15,000. You would also have to put up the mark to market price of the put option and that value will change daily. In this case it is $35,000.

    The strategy is most effective when you are selling front month out of the money options to take advantage of time decay. I have a 4 hour video course that teaches you how to use this strategy effectively.

    http://www.oneoption.com/Products.aspx?product=8

  • On 10/13, charles patterson said:

    If I sell a 3 month put, naked or not, with a high 15% monthly dividend, am I required, liable to pay the dividend to the owner of the put I sold?

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