We have enjoyed two strong days in the stock market. On a pullback, one strategy you might wish to consider is to short puts on a stock that you like and do not own. This is called a naked put or uncovered put position.
Why short puts?
I am occasionally shorting out of the money puts on stocks that I do not think will go significantly higher from current levels and—this part is important—would be comfortable owning at the strike price. Because current volatility is high, options are relatively expensive. And, all options decay with time. That is, if the stock price were to remain at a stationary price, the out of the money put options would become cheaper as the expiration date approaches. And, if the put expires out of the money, I keep the entire put purchase price.
If the stock price moves upwards, the put options decrease in price. You can either buy back the put options to lock-in a gain. Or, you can continue to wait, hoping that the options expire worthless. What I decide to do is largely a function of how much the stocks have moved upwards and how much time remains before the options expire. For example, if recently I initiated a short put position with one month to expiration and we enjoyed a strong two day rally of over ten percent, I would close out my short put position to lock-in the gains.
If the stock price plummets such that the out of the money puts are now in the money puts, you have two options. One, you can buy the put options back for a reduced profit or loss. Depending on how far in the money the puts are, you might be in a loss position, but not necessarily. It depends on how deeply the puts are in the money. Or two, you can wait for expiration and be assigned the put. In theory, you could be assigned the put at any time the puts are in the money; however, with the current high volatility and low interest rate, the put holder is better to sell rather than exercise the puts.
Remember at the very outset, I determined that I would be comfortable owning the stock at the strike price. In reality, you would own the stock at the strike price less the initial short put price (plus commissions). For example, if you sold puts (naked puts) on stock ZZZZ for $5.00 with a strike price of $100.00, your effective purchase price is $95.00. One important thing to keep in mind is that your comfortable price today may change once the stock has defiantly punctured that floor price. In other words, you might be happy initially owning ZZZZ at $100.00. But on a sudden meltdown where ZZZZ plummets to $80.00, you will wonder how could you have ever been comfortable with owning ZZZZ at $100.00. The key point is that you must continue to monitor your position because your comfortable floor price might change with market or stock conditions.
Let us look at an example using Apple Inc. (AAPL). Assume that we believe that Apple's stock price will remain turbulent for the next several months. We do not believe that Apple will snap back to well over a $100 and stay there. So we want to sell out of the money put options to capture the premium. Please note, this is purely a hypothetical example. I am in not recommending this trade or investment. In other words, you must arrive at your own decisions.
Today, Apple closed at $92.95, up $10.37. Below is a one year chart of Apple. If you click through, you can view a larger image.
Assume that you are comfortable owning the stock at $75 under any conditions. Looking at Yahoo Finance Apple Option Quotes, we note that the December $75 options are bid $2.02 and ask $2.08, down approximately $2.95. Because we just experienced a strong two day rally, you decide not to enter the trade at these prices. Instead, you wait for a pullback.
Let us further assume that tomorrow morning the markets go down heavily. Apple reverses today's gain of $10.37, goes back to $82.58 and the put options prices go up $3.00 to $5.10. Now you execute the trade. Under this scenario, you gain $5.10 as long as Apple remains above $75 per share. If the stock is going to expire below $75.00, you will either be required to purchase the put option back prior to or upon expiration or be assigned the put option, meaning you will be forced to purchase the stock.
If the stock closes between $69.90 and $75.00, you win. You win because you effectively paid $69.90 ( = $75.00 - $5.10 ) for a stock that is worth $69.90 or greater.
If the stock expires below $69.90, you lose. For example, if the stock expired at $60.00, then you lost $9.90. Your initial premise, however, was that you were willing to own Apple at $75.00 under any conditions. If Apple were to expire at $60.00 in December, that would certainly test how honest you were with yourself.
By having a naked short out of the money put position, you are paid to provide insurance until expiration. If the stock remains above our strike price, you keep the entire put purchase price. If the stock is going to expire below the strike price, you will be forced to cover prior to or upon expiration or to purchase the stock.
What are some of the risks with this strategy?
One obvious risk is that Apple takes off over $100 and never looks back. While you keep the put purchase price of $5.10, that is a small consolation prize. If you had purchased Apple stock outright, your gains would be much, much larger. Again, our initial thoughts were that Apple would remain range bound for the next several months.
Another risk is that Apple expires at a low price, say $60.00 or lower. While you were initially content with purchasing Apple at $75, you now have buyers' remorse at having paid an effective price of $69.90.
Yet another risk is that you sold naked too many put options. You initially thought to yourself, how could Apple ever possibly go below $75.00 and sold a ton of naked put options? Much to your extreme surprise and disappointment, the unthinkable happened—the stock market crashed quickly taking Apple along with it. Now, you have too much expensive Apple stock sitting in your portfolio.
The three mentioned risks are the obvious ones.
Some people incorrectly believe that selling naked put options is extremely dangerous. The reality is that naked put options are very similar to a long stock and short call position. That is, if the stock rises dramatically, your gains are limited. If the stock just sits there and does nothing, you capture the price for the puts (or calls). If the stock tanks, you suffer the consequences. Where naked puts are dangerous is where you get over your head and short too many put contracts. This is the third risk that I mentioned above. Then, you have the potential to do major harm to your portfolio. Thus, before employing this strategy, you need to ask yourself, am I comfortable with owning the stock at the strike price (or more precisely at the effective price which is the strike price less the put price plus commissions)?
With volatility being high, I like this strategy for certain stocks. Please note, again, the Apple example is a hypothetical example only. You must decide which stocks, if any, are appropriate for you and at which strike prices you are comfortable. And, you should likely wait for a pullback before employing this strategy.
If option strategies interest you, I highly encourage you to read my friend Adam Warner's blog Daily Options Report. Adam provides much more detail and much more insight than I do in my high level discussion in this article.
Disclosure: I have no positions in Apple.
My photograph of Calgary at Night is hosted at Flickr. If you click on the picture, you will be taken to my Flickr account where you can see more pictures.
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