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Rolling Naked Put Options For a Credit - A “Down and Out” Option Strategy!

Posted by Pete Stolcers on March 11, 2008

This is a previously published article that is very relavant. We are in a bearish market and this strategy would have crushed you.

There is a strategy is known as “rolling for credits”. Let me describe the situation. When you sell a naked put, you are taking a stance. You really like a stock and you are willing to buy shares at a lower price. If the stock never drops and you never get the chance to buy it cheaper, you will be rewarded by the option premium you collected. Even stocks that represent a great “value” can fall much more than expected and every naked put writing strategy should include a well-defined support level. Before the option goes in-the-money, that support has to be breached. This resting point will give you a chance to reconsider the trade. This article is categorized in my blog under Trade Management and not under Option Strategies. That’s because no one goes into the position with the belief that they will have to roll “down and out”.

In general, naked puts carry the same risk as being long the stock once they are in-the-money. There are many “gurus” who will tell you to simply “repair” the strategy if the stock moves against you. They advise buying the front month short put and selling a farther out-of-the-money put with greater time until expiration. Since you are selling a put with more time, the premium will be greater and you can often do it for a credit. The new put is out-of-the-money so you don’t have to worry about assignment. When the new short put expires, you will have effectively avoided a loss and captured a profit. HOGWASH!

I speak from personal experience when I attack this “repair” strategy from many perspectives. I’ve tried it and I’ve had thousands of customers try it – unsuccessfully. Let me start with the biggest issue. The stock did the unexpected and broke a support level that warned you. At that point, you should close the trade, take your loss and admit that you were wrong. If you REALLY like the stock, watch it and wait for it to find support. I’m not talking about a “dead cat” bounce, I mean support that has been tested at least once and has formed over months. You’ll be surprised how far your “hot stock” can fall. Once this support has been established, consider writing a naked out-of-the-money put with the intent of purchasing the stock. If the stock breaks the new support level, take your loss and consider walking away from the pick. There is obviously something really wrong with the company. Fooled me once… fooled me twice…

One of the biggest pitfalls of trading is the inability to admit that you are wrong and the market is right. It’s the reason people don’t honor stops and the reason they seek “repair” strategies. We are not dealing with a house where we can rip apart a wall and find the leaking water pipe. That can be repaired. Traders are dealing with a stock and our information is never as good as everyone Else’s. When the price action tells us to get out, we have to respect it. Long before the Enron fraud was revealed, the chart was telling you – GET OUT. The insiders and institutions were bailing out way ahead of time and their sources were picking up on the warning signs. The other issue with a “repair” strategy is that you never intended to own the stock. If you sold a naked put because you just wanted to collect the premium, you are probably over-leveraged and you can’t afford to buy the stock. That in and of itself is a problem and you are forced to buy-in the short. For naked put writing you should always hold half of the strike price in reserve so that you can afford to buy the stock on margin (Reg-T). If you can’t afford to buy the stock you should consider a put credit spread.

In addition to the psychological issues, the strategy is impractical. When you buy-in the front month and sell a back month option, you will not be able to go one month out, you will have to go many months out. Let’s first dispel the notion of selling the same strike and rolling out to the next month. Once the option is in-the-money, it will have some intrinsic value and a time premium component. The amount of additional premium will be negligible. A small push lower will put it further in-the-money and once again, it will be in jeopardy of assignment. I was looking for a $50 stock (a common price level for most stocks) and I picked this stock randomly to give you an actual example. IGT has been in a very strong up trend and it has been a consistent performer both technically and fundamentally.
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The rationale for this trade could have been to get long on the $45 breakout. Instead of buying calls you decide to sell the February 45 puts for $.80 with the idea that the breakout level represents support. If the stock continues higher, the put will expire and you will collect the premium. You also theorize that stock might test the breakout (support) before heading higher and you can take advantage of time premium decay. Today the stock broke the key $45 support level. The Feb 45 puts are trading at $1.75 and the March puts are trading for $2.10. You can roll the position to the March 45 puts but you are only picking up and extra $.35. After commissions – big deal. You are not providing much more protection and you are adding a month of risk exposure. Remember, the risk can come in the form of the stock, the group, the sector or the overall market. With the stock trading at $43.60, the March options are only trading $.50 over parity and with another push lower, they will be quickly be trading at intrinsic value. Given this scenario, the position will once again be subjected to the risk of assignment. Now let’s see how far out in time we need to go to sell the $40 strike. Remember, we are trying to generate a credit so we need to bring in more than $1.75. We have to go all the way out to Jan 2008 where the Jan 40 puts are bid for $1.90. WE ARE TAKING ON A YEAR OF ADDITIONAL RISK TO AVOID A LOSS AND MAKE A TOTAL OF $.95. We took in the original $.80 and we took in an additional $.15 on the roll.

You can find fault with my example and there are a million different scenarios. I’m sure I will hear from some traders that this example uses a low IV option and it works better with high IV scenarios. My response to that is that the “big” premium is there for a reason. Higher IV means greater uncertainty. You might not have to go out a year, but you will certainly have to span a couple earnings releases. Also, you are buying in a higher IV option to do the roll. Bottom-line, the net credit will not be commensurate with the additional duration of the trade. This stock has broken support and the risk/reward is poor.

The strategy reads well in a book but that’s a good as it gets. I’m not going to turn this into an article on how to properly sell naked put options, but here are a few of my rules. 1. Only sell naked puts on stocks you want to own. 2. Only sell puts below a well-defined support level. 3. Always make sure you have half of the strike in reserve so that you can afford buy the stock. 5. Know the company and make sure that news events are not looming. 5. If you get assigned, re-evaluate the company and decide to; sell the shares, hold the stock, or sell calls against the stock for added protection.

When you read articles on option trading, avoid “repair strategies”. From my perspective, a bad trade is a bad trade. You often need to establish your loss and get the bad taste out of your mouth before you can objectively look at the stock again. Once you’ve wiped the slate clean and put the trade behind you, you an consider a future position. At that time, it will be a “new” trade and it will need to stand on its own merit.

Please share your experiences.

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Option Trading Comments

  • On 09/30, Roger said:

    I have just started option trading and my goal is to try and make approx. 30% annual return.  Selecting a stable stock with good fundamentals ie International Paper and long on 100 shares and sell a 30 day put just a little below (and I would not mind owning another 100 shares) and selling a call just a little above.  Is this a worthwihile strategy?  I would like to keep it fairly on the conservative side.  Thanks

  • On 10/02, Pete Stolcers said:

    This is a great strategy and your expectations are in-line. The key will be in your stock selection. Make sure to spend the majority of your time researching the stock. Use fundamental analysis to confirm the selection and use technical analysis to guide you with the entry and exit parameters.

  • On 11/11, Frank said:

    Pete, I just started looking at some of these posts and came across this.  Your numbers, and your opinion tell the true story of the flawed concept of repair strategies.  I wish I could have had this information six years ago.  My experience has been that, in addition to what you have described, the repair strategy takes forever to recover, if you ever recover.  What this tends to do is slowly cause you to build up a collection of failed trades in you account that you are trying to repair.  You eventually chase pennies to try to repair dollars/tens-of-dollars of loss in the stock price.  Also, because of this, your working capital is greatly reduced, so you have fewer and fewer productive trades because you do not have the ability to create enough positions.

  • On 11/11, Pete Stolcers said:

    Hi Frank. Well put from a person that has lived it. I hate looking at a position that is a constant reminder of a bad decision. Know when it is time to admit you are wrong and move on.

  • On 02/18, Rick said:

    Pete,

    I’m building a strategy to assist me in exiting a long SDS position (which has been nicely profitable in this bear market).

    First, I am using the SDS as a hedge, not necessarily as a profit center (although I seem to have slowly accumulated a net short market posture in one of my accounts).

    My approach is to sell the “just” OTM calls in the near month, together with farther OTM calls. It is a covered strategy - as I said, I’m looking of exit assistance once I’m convinced/believe that we’re within 5% of the final bottom on the $SPX.

    In the face of sharp rallies (in SDS - market dips in the SPX), I’ve “repaired” (to use your terminology) the near month calls that become more than 1.5 pts into the money.

    As SDS is not an individual stock, but rather an index following ETF (double inverse to SPY), and since I am looking for “exit help” - it seems picking a bottom is the graveyard of lots of traders - I am guessing that my approach may not be as much “hogwash” as with respect to an individual stock. But I could use some help in knowing when “enough’s enough”. So far, I’ve been able to roll horizontal or diagonally for at least an “even” or some credit.

    But if IV collapses, I can see difficulties in rolling, and I’m afraid I might still be uncertain of the prudence to chase (if the market goes further south, thereby putting my SDS calls into the money), or let the underlying go. (I’ve not yet read your article on using Deltas, but will by the time you reply - so any comments using deltas would be helpful.)

    Thanks,
    Rick

  • On 02/18, Pete Stolcers said:

    Hi Rick,

    The SDS is a bit of a strange annimal for most to comprehend because it is inverse. I am going to translate this into a more conventional hedge. My reply should still answer your question.

    In essence, you are short the SPY (S&P;500 Depository Receipt). Again, for simplicity, lets say that you are long ITM SPY puts that are trading at parity. You did this to hedge long stock positions. This strategy works well if your stocks are strong relative to the market since they will hold up better than the index. The hedge is one transaction and you can quickly place it and remove it. It is one position (versus many stock holdings).

    As the market tanked in January, you decided to sell some OTM puts against your ITM put position. You could have done this for two reasons. 1. You thought the low was established. 2. You wanted to take advantage of higher IVs.

    In essence, you have created a put debit spread to act as a hedge. Unfortunately, it will only give you a little downside protection. If the market collapses, the value of the put debit spread will max out quickly and your portfolio will suffer unhedged losses beyond that point.

    Here is how I would handle it. If the market is able to rally above SPY 140 (recent relative high) I would sell the long puts and leave the short puts to expire (with a stop in case the market reverses). You are removing the hedge so that your stocks can run. If the market breaks below SPY 132 (recent relative low and support level from March/August/February), you buy in the closer to the money puts. If the market breaks below SPY 125 (the capitulation low in January) you buy in the farther out puts. This will leave you long the ITM puts and your hedge is back on.

    When the market eventually finds support, you can sell your puts and just hold your long stock position.

    In short, on a market breakout, sell the SDS and keep your short call positions (with a stop). On a market breakdown, buy in your short calls and stay long the SDS until the market finds supoort.

    I hope this helps.

  • On 03/21, Lawrence Chiu said:

    I was wondering if you can answer a question I had about writing naked options and the risk of having to take a position in the underlying.  My question is regarding an out-of-the-money option and expiration day.  What happens to the option if the company announces major news that causes the stock to run up or down in a big way?

    For example, if I am short:
    2 contracts of Baidu March 08 $210 calls
    and Baidu closed at $207.90 at 16:00 PM Eastern on expiration day March 20, 2008. 

    What if in a fantasy scenario, Baidu announces that Microsoft is buying them, the stock shoots up to $220 after-hours....  can I get called to the carpet and will see a negative 200 share-position in Baidu on Monday the following week?

    If the answer is yes, how much time does the options buyer have?  What if the news came out on Saturday or Sunday?  Is it too late to exercise?

    Thank you so much.

  • On 03/21, Pete Stolcers said:

    All exercise notices need to be submitted no later than 15 minutes after the close of business on the last day of trading (normally Friday, but with the Easter Holiday it was Thursday for this expiration cycle).

    20 years ago, the exercise notices needed to be submitted before 6:00 pm ET and there were a few instances where material news was released after the close and the holders of options took advantage of the situation. That prompted the rule change.

  • On 03/22, Lawrence Chiu said:

    Hi Pete, Thank you for that information.  I read on the Options Industry Council’s website that the cut off time is 5:30 Eastern Time.

    Link:
    http://www.optionseducation.org/help/faq/exercise.jsp

    Quote:
    “Options exchanges have a cut-off time of 4:30 pm, Central Time, for receiving an exercise notice.”

  • On 03/23, Jeff Stevens said:

    Hi Pete,

    Just stumbled across your site cruising the internet for financial info.

    I am a professional options trader, and your 3/11 article above on the folly of the naked put credit rollouts is right on.

    The correct trade in your IGT senario in my opinion would have been to use a bull debit spread, i.e., buy the 45 calls and sell the 50s or the 55s against them to reduce you net long cost. That way, if the stock broke support, you could at some point close out the callers for a profit, and then roll out your calls if necessary/desired. Or you could just take a modest loss and move on. Or if you are incredibly bullish, you could rolldown and out the calls (this could get expensive, though).

    The bull credit put risks too many $$$ for too little reward, as you point out. And then to try to trade your way out the mess only compounds the problem.

    Keep up the good work!

  • On 03/24, evi said:

    Rolling Naked Put Options For a Credit - A “Down and Out” Option Strategy!

    I used that strategy and it works for me.
    The strategy is: You have to ONLY selling Naked FAR Out The Money PUT and do it at indexes, more liquidity and not too much volatility. And only used maximum 30% of your capital when you sell that options.

    See my trading record at:
    www.optionstradingdiary.com

  • On 03/24, Pete Stolcers said:

    That cut-off is correct, however, it pertains to how long the brokerage firms have to report the exercise notice to the exchange. Brokerage firms need time to process the requests before they can submit them and their cut off for their customers is soon after the close (usually 15 minutes). 

    Corporations look for non-trading periods to release material news and they would not announce after the bell on Friday. They are likely to wait until Sunday night/Monday morning.

  • On 03/25, Pete Stolcers said:

    Hi Jeff,

    I agree with your long call concept on IGT. A strong chart like that deserves a more bullish stance. When you are long calls, it is easier to take the loss since your risk is limited. As the position moves against you, the delta decreases and it is a little easier to come to grips with the reality that you made a bad trade. For some reason, put sellers that get into trouble think differently.

    I believe it is because the losses keep mounting as the position moves against them.

    Thanks for the comment.

  • On 03/25, Pete Stolcers said:

    Hi EVI,

    I like selling OTM index puts. There is an edge because those options carry greater IVs since institiutions buy them as a hedge for their portfolios.

    The index is diversified and it does not pose the same risks as being short an equity put option. In the vast majority of cases rolling down and out will prove successful for that reason. Stocks on the other hand tend to go down much farther than they should.

    That said, you do still need to have a stop on the trade and you need to know when not to roll. There were many traders that rolled positions and got carried out in body bags in 1987 and 1989.

  • On 03/29, Jeff Stevens said:

    Hi Evi,

    Re your 3/24 post, risking 30% or your capital on such a position seems too much. I never risk more than 3% of my working capital on any single options position. That way, if it is a total washout (which I define as a 50% loss on the position - I’m gone), it only nicks me by 1.5% on the aggregate.

    Of course I have to do it this way because I have nothing else to do, and if I lose my capital, I have no job!!!!!!!!

    Fear is a great motivator in my case!

    Sincerely,

    Jeff.

  • On 03/29, Pete Stolcers said:

    Hi Jeff,

    While I don’t recall the 30% reference, I completely agree with your response. This is the easiest business to start and the hardest one to grow. The key is never putting up the going out of business sign.

    I try never to allocate more than 5% of my capital to one trade. Having said that, I am much more agressive in my services. Unfortunately, people that subscribe to a speculative service expect returns in excess of 50% per year and you can’t make that return without taking on more risk.

    Subscribers who are happy with smaller returns throttle back on my positions, and keep a larger cash (t-bill) reserve.  I highly encourage that. 

    Thanks for the excellent comment.

  • On 03/29, Jeff Steven said:

    Hi Pete,

    I gather from your 1/25 post and other articles of yours that I have read that you would just buy the calls in the IGT example, i.e., would not do the debit spread, which limits your upside, doubles commission costs, and doubles the bid/ask spread battle.

    Well, I would have no problem with that, but then I would reduce the size of the position so that the total maximum loss up front would be the same as in the debit spread.

    One sweet thing about the debit spread is that sometimes the stock will rise right up to the short call strike at expiration. You usually get at least one opportunity to close out the callers for 0.05 that day (as part a two-legged spread close-out trade). Also, it helps reduce the day-of-expiration “low bid” rip-off strategy that I know you are aware of.

    Enjoy your analysis and comments.

    Jeffrey.

  • On 07/15, Mark said:

    Going back a couple of weeks ago when DIA was trading at about 116 I did a ratio put spread where I bought 10 july 114 put contracts and sold 20 July 111 put contracts for a credit of .25 .  That basically leaves me with a profit if at experation it is between 114 and 108.  On Friday sensing some panic in the market I decided to buy july 30 vix options to hedge against a sharp decline While still leaving room for a nice profit.  My question is in the event there is a sharp decline should I exit the position at a certain point with a small loss (and if yes at what point) or should I let it play out and roll down and out part of my naked puts for a credit if I need to figuring there would be very high implied volatility in the event that a sharp decline would take place? Also was buying the vix options as a hedge for my purpose a smart move or was there a more effective way to accomplish the same thing? 
    Thank you

  • On 07/16, Pete Stolcers said:

    Personally, I think you are over complicating the trade. The ratio has worked out fine. Instead of buying VIX options as a hedge, you should have taken some profits. You suspected that there was a rally coming and you were right.

    I don’t like trading the VIX options because of the bid/ask slippage. I feel like I am giving away too much of an edge.

    The exception is a longer term move in IV. In May 2007, I went long ITM November VIX calls because I felt long term IV would rise.

  • On 06/25, Paul said:

    Hi Pete and thanks for the article. 

    I’m teaching myself to trade options by reading and by practicing with a small account.  I recently was able to roll over a put that was about to expire in the money and did it to see how it worked.  The strike price was 14 and the stock had dropped down to 12.  I was able to roll over the 14 put from June to July, 10 minutes before expiration, and pocket a 50 cent premium.  Theoretically this could be done repeatedly until the cumulative premiums exceeded the drop in price of the stock resulting in a profit.  The problem of course is the stock may tank completely and, even if it doesn’t, more profit can be made by taking the losses now and selling a put where I think the stock will close at expiration (if it makes sense to do so considering other courses of action available).

    My strategy as it is now (its still under development) is to choose a stock that I am bullish on that has good implied volatility.  I sell a range of current month calls with strike prices as close to where I think the stock will close at expiration.  If any expire in the money, I buy the stock and issue a call at where I think it will be the next month.  Likewise, if a call expires in the money and I sell the stock I hold the proceeds and sell a put again.

    Does this sound like a good strategy or are there problems I don’t see yet?  As I said I am still learning.

    I find that when you use options to limit potential losses you are more likely to experience them and likewise, if you use options to limit potential gains you are more likely to experience them.  It therefore seems better to use a cash or stock position as one leg of an options trade to skew the results in your favor much in the same way an insurance company makes money by accepting small premiums to protect against large, unlikely losses or a casino makes money facilitating gambling.  Does that make sense?

  • On 06/26, Pete Stolcers said:

    All of your strategies are vailid, but it really comes down to your ability to forecast stock movements.

    The one issue I see with your approach is that you are always assuming your forecast is correct and that eventually the stock will “cooperate”. Make sure that you review the news and watch for material events that can change the fundamentals. Also watch for key breakdowns in the stock and also watch the market. These factors will all influence the stock and there will be times when you have to close a position, take your lumps and move on.

  • On 06/26, Paul said:

    as I said, I decided that it is better to let it expire and issue a new call or put based on a new prediction of the stock movement based on current news. 

    In this case there is a good chance HIG will rise back to 14 so keeping a few at that price combined with several at and near the money puts is probably a good strategy. I will see how it plays out. I have several 11 and 12 puts on the stock which are currently out of the money and my overall break even point for this month is 11.  The stock is now trading at 12.2. 

    IV is slightly down and an in-the-money, current month put or call on this stock is trading at a premium of about $1 or about 8% of the stock price.  That means that selling a neutral at-the-money put gives 8% profit potential in less than one month with 8% downside protection.

    Although I think it is possible to roll over the puts and eventually break even on the premiums collected (at least with HIG the way its trading now - which could change) The best course is to let them expire and issue a new option at a strike price based on the current situation.  Or even keep a portfolio of options in a range of strike prices the stock is likely to reach.

    I have yet to decide whether it is better to use a spread of exercise prices or pick the most likely one to save on commissions.  As I tend to start out slow and add to my position as the month progresses and the stock movement becomes clearer, a portfolio would probably be best.

    Since I am covering my puts with cash reserves instead of using margin and I don’t care about the tax implementations I don’t mind letting the options expire in the money and switching between calls and puts as appropriate.

    I find the maximum profit can be made for a given risk threshold if you issue the option at the strike price that the stock closes at at expiration as long as you don’t mind it being exercised.  If you are bullish you pick a higher strike price and if you are bearish you pick a lower strike price if the premium makes sense to do so. 

    Of course, as the market changes, this strategy may stop working so I need to know how vulnerable it is to different market situations and what situations to look out for.

  • On 06/26, Paul said:

    One more thing.  On this stock the IV is lower than the HV.  That means that statistically you will loose more often but it should even out over time.  If the HV was greater than the IV then loosing on a short put would indicate that you missed something major in your analysis of the stock and it would be better to close your position and cut your losses.

    This particular stock is very susceptible to investor sentiment on the economy and the volatility reflects that.  If the economy improves, HIG will go up faster, if it falters, HIG will drop faster.  Its price tends to overreact to news on the economy but it did pass the Government’s stress test giving some assurance that it will survive.

  • On 04/16, Rakesh said:

    What do you think about this strategy:

    So sold the $45 puts for stock ABC which is trading at 50 for $ 0.9 and unfortunately it got exercised at 45.

    Considering that it was a bad trade and market and stock is likely to fall even further, why not short same number of ABC stocks itself against the stocks that you were forced to buy from put exercise. Rather than taking a loss on buying back the put or exposing the stock to fall further , in case you don’t like to own this stock.

  • On 04/19, Pete Stolcers said:

    Once you were assigned the stock, you are long shares at $44.10. If you sell shares, you are flat and you have no position! At that stage, you have already taken your loss.

  • On 02/10, Len said:

    I am looking into selling Puts. I have a handle on which one’s to sell but am having difficulty trying to develop an exit strategy. Can any one give me a few tips on the kind of things that have worked for them?

  • On 02/11, Pete Stolcers said:

    I have a course where I cover that topic extensively. It is called “covered Call Sritting - the right Way!. You can find it at http://www.oneoption.com

    In short, sell puts below major support. If that support fails, buy them back. If not, let the options expire. Only use this stragegy on stocks that you would like to own. If you sell nake puts long enough, sooner or later you will get assigned and you need to like the stock.

  • On 05/20, Glen said:

    Put writing is worthwhile given that strict safeguards are employed.Write on stocks that would pay a high dividend to you if you are assigned-stocks like Altria or Southern.If you are put, collect your dividends and write calls at the strike price.Wtite on stocks in different sectors to avoid too many assignments if a sector goes down drmatically.Write on days when the stock in question goes down.Keep cash equal to the strike price as collateral.DO keep rolling out for credits.Over time, you`ll earn a fine return on the money you`ve put aside as collateral for it is that money that is your basis for your put writing investment.

  • On 06/24, Jim said:

    Hi Pete - Can you comment on the rolling forward strategy with ETF’s, specifically SPY.  Alot of the risks you described were stock or industry specific.  With SPY you can eliminate this.  Would you consider this strategy for SPY?
    Thanks
    Jim
    PS Great article.

  • On 06/27, Pete Stolcers said:

    You can roll forward with any underlying, but be careful. The market can go down for long periods of time and if you tried this repair strategy in 2008-2009 on a put credit spread you lost your butt.

    You need to respect technical breakdowns and most of the time you will be better off buying back the position, taking your lumps and moving on.

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