Noise and the Naked Put

Like the naked city, there are a thousand horror stories about the naked put. Some traders will tell you that selling put options is the worst strategy to use. Regaling countless stories about investors who have been wiped out because of adverse moves in the market.

Too bad really! Naked put writing can be a powerful tool that allows you to engage the market during periods of uncertainty. As if there were ever a period when uncertainty did not exist?

In the current environment there are marked difference between the bull and bear camps. From the “don’t-fight-the-Fed-camp” bulls highlight the unlimited support coming from central banks and the fact that corporate America is awash in cash as constructive. The bears are focusing on the risks associated with an unlimited bond buying program, uncertainty around the US presidential election and the looming fiscal cliff.

Both sides have solid arguments which is typical at major turning points. The result is a market where prices spike on sentiment but for the most part churn in a narrow trading range. Also of note is the lackluster volume which suggests that retail investors have yet to stake a claim in the current environment.

In this context naked put writing offers an interesting compromise. A strategy that gets you off the fence but allows you to remain close to the sidelines. The trick is to use put writing as an alternative to the limit order and not as a speculative trading strategy.

When you sell a put option you are committing to buy the underlying stock at the strike price of the put. If you sold the Potash (TSX: POT) January 42 put, for example, you would be obligated until the January expiration, to buy Potash common stock at $42 (the strike price) per share.

When Potash was trading at $42.73 (Friday’s close) the January 42 puts were changing hands at $2.00 per share. When you sell the put you collect the $2.00 per share premium which you retain regardless of what happens to Potash between now and the January expiration.

The maximum potential from this trade is the $2 per share premium which occurs if Potash closes above $42 per share at the January expiration. At that point the puts would simply expire worthless because traders who purchased these puts will not force anyone to buy shares at $42 if they can sell the same shares in the open market at a price above $42.

The downside risk is greater in that the stock could theoretically decline to zero. In that worst case scenario you would be forced to buy Potash at $42 per share although your actual cost would be $40 ($42 strike price less $2 per share premium = $40). To some that is not an attractive risk / reward; potentially risking $40 ($42 strike less $2 premium) for the chance to earn $2 per share.

That said, the maximum risk is theoretical. The chances of Potash declining to zero is low. Especially between now and the January expiration. More to the point if that were a concern you would avoid the stock which means the risk has more to do with the investment implications related to Potash than it does with the strategy.

The naked put is useful if you think Potash is a reasonable investment but believe the current $42.73 price is too high. I suspect that is something you have dealt with previously. Even if you ever never traded options you have probably used “limit” orders. Rather than buying shares “at the market” you enter a “limit” order which sets the maximum price you are willing to pay for the stock.

The limit order obligates you to buy at a specific price in the same way as a naked put obligates you to buy at the “strike” price. But with the sale of the put you earn a fee (i.e. the $2.00 per share premium) and unlike the limit order, may not necessarily buy the shares at the strike price. Only if the put is assigned will you actually end up with the shares.

So why did such a basic strategy get such a bad reputation? The answer is leverage! When you enter a limit order you typically set aside capital to buy the stock. Too many investors sell naked put options as a trading strategy never expecting to be assigned.

If you are over-leveraged and the underlying stock gets pummeled by an unexpected event it affects the put writer from two perspectives. The price of the put increases because; 1) the stock is declining and 2) volatility is increasing.

Think of it this way. When a stock falls sharply on bad news holders of that stock scramble to buy puts as insurance and will pay up for the protection. Much as one might pay any price to buy fire insurance when their house is burning down.

The volatility component of the option pricing formula quantifies that rush to the exits and factors it into the put option’s price. Put writers who are leveraged get hit with margin calls and often end up closing their position prematurely… typically with a huge loss.

If you are engaging in put writing as an alternative to a limit order you should be expecting an assignment and should be willing to hold the underlying stock and obviously should set aside the necessary cash to meet the assignment. Under this scenario, the naked put becomes just another portfolio management tool rather than a menacing threat to your pocketbook.