The Basics: Considering Naked Put Writing?

“Responding to a simple request: Please provide your opinion on selling naked puts; both pro & con.”

I assume we are referring to cash-secured put writing, rather than selling naked puts.

Here are the PROs:

It can be better than buying stocks outright because you can get a better entry price (stock price is reduced by the premium collected).

It is a bit less risky than owning stocks – by amount of premium collected. However, the put seller can incur a large loss (maximum occurs when stock price goes to zero).

If put expires worthless, you keep the premium with zero further risk

When bidding for stock (at a limit price), you often don’t buy the shares, The put premium is a consolation prize when you never get to buy stock

It is likely more efficient than writing covered calls, an equivalent strategy. There is one trade and one commission,  instead of two.

It can be much easier to exit the trade prior to expiration. It is easy to buy the put if it declines to $0.05 or $0.10. It is much more difficult to exit the covered call position.

**Avoids belief that a rally is bad (see below)

The CONs:

The position is similar to owning stocks giving it a huge downside risk

The put seller may miss an opportunity to buy stock. Writing a covered call eliminates this risk.

The biggest ‘negative’ is not recognizing the risk and thus, selling far too many puts. This is common rookie error. If you would buy 200 shares and sell two calls, then the appropriate size is to sell two cash-secured puts.

COMMENTARY

Compared with selling cash-secured puts, selling put spreads cuts both profit and loss potential. This play is preferred by many risk-averse traders, but it is not for everyone.

**One myth destroyed

Many covered call writers believe that a big rally in the stock price is a risk. They feel that if they had not written the covered call, they would have earned more money. To me this is not the correct mindset for a trader. We chose to write the covered call for good reasons, and cannot expect every investment/trade decision to produce the best possible result.

We know that selling naked puts is the equivalent strategy. When the stock rallies and the put becomes inexpensive or worthless, the cash-secured put seller is happy. The put seller does not see any ‘risk’ when the stock rallies, and neither should the covered call writer.

The upside produces the maximum possible profit for the position. If a rally is good for the put seller, it is likely good for the covered call writer.

Mark D Wolfinger
Options for Rookies
May 17, 2012

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