One tactic Lawrence McMillan uses to analyze naked puts.
You've come to the realization that you like a certain company and "wouldn't mind owning it." With this bullish sentiment, you decide to sell a short put. Your main intention is to collect the credit, but you know that you may be forced to buy the stock if it falls below your strike. In my experience, to simply think highly of a company is not sufficient analysis for an option trade. Within this post I discuss some ways to aid in your trade evaluation.
To learn more about naked puts, please see Play #4 of The Options Playbook located in TradeKing's Education Center.
THE PLAY - Short Put
TRADE FORMATION
On June 17th at 10:49am, Community member S90911 entered TRADE 1:
Strike A Put: Sold to open 1 ETN June 95 put (ETN RS) at 0.50
Stock at entry: ETN near 96.50
Trade entry: 0.50 credit
Maximum gain: 0.50 credit received
Maximum loss: 94.50 (Strike A - credit received)
Break-even point at expiration: 94.50 (Strike A - credit received)
On June 20th at 2:42 pm, the trader closed the trade.
Strike A Put: Bought to close 1 ETN June 95 put (ETN RS) for 1.80.
Stock at entry: ETN near 93.50
Loss on trade: 0.50 - 1.80 = 1.30
On July 7th at 12:10pm, the trader entered TRADE 2:
Strike A Put: Sold to open 1 ETN July 80 put (ETN SP) for 1.30
Stock at entry: ETN near 83
Trade entry: 1.30 credit
Maximum gain: 1.30 credit received
Maximum loss: 78.70 (Strike A - credit received)
Break-even point at expiration: 78.70 (Strike A - credit received)
ALL-STAR COMMENTARY
Naked put selling is one of our specialties, in that we manage a considerable amount of money in that strategy. So, let me begin with Trade 1:
To say "Great company" is not analysis, and even if it were true, that doesn't mean that randomly selling puts on it would be a good trade. To actually analyze the trade, one must use an expected return calculator or a probability calculator or something similar, to incorporate the volatility of the stocks, to see whether the put sale is justified.
In this case, we don't know the stock price for sure at the time of the sale, but it was probably around 96.50, as it was higher in the morning. It traded down later in the day. These puts were set to expire in three days. That is too short of time to do a meaningful expected return calculation, so we'll merely use a probability calculation.
At the time of the sale, the 20-day, 50-day, and 100-day historical volatilities of ETN were all near 32%. So, we'll use that as the volatility. At the same time, the implied volatility of the ETN put options was about 32%. Because there is no divergence between the historical and implied volatilities, there was very little "edge" in selling the put. Using our Probability Calculator, we find the following:
Probability of put expires worthless: 67% (i.e., the stock is above 95 at expiration)
Probability of trade makes some money 72% (i.e., the stock is above 94-1/2 at expiration)
Probability of stock falling below break-even point of 94.50 any time before expiration: 37%
Those are not bad percentages. I prefer a probability of 20% or less of the stock falling below the break-even point, however these numbers are acceptable.
The Probability Calculator shows the above results in Figure 1:
Click here for a larger image.
Three days later, the stock had fallen to 93.50 and so the trader covered the put at 1.80 and took the loss. This is by far the most prudent course of action. The trade didn't really work out as planned (I'm sure that the trader expected and wanted the put to expire worthless). Covering with a manageable loss was definitely the correct thing to do. Interest in wanting to own the stock has surely waned.
A couple of weeks later, on July 7, the stock had fallen sharply, into the low 80s. Once again, the trader attempts a put sale. Unfortunately no detailed analysis is mentioned. That doesn't mean the put isn't a good sale, however.
By this time, implied volatility has skyrocketed, as is often the case when a stock drops sharply. Ironically, the historical volatility of ETN had not increased that much. So, on July 7, the put was overvalued and there was an "edge" in selling it. Explicitly, the put being sold (July 80 put) at 1.30 is now nearly 48% implied volatility, a distinct edge over the statistical volatility of the stock, which was still near 32%. Because the implied volatility had increased drastically when the historical volatility had barely changed, an option selling opportunity was created. The probability calculator agrees, of course, and calculates the probability of the stock ever trading below the breakeven (78.70) at any point prior to expiration is only 5%. Thus, this is a good put sale.
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Larry's previous posts: MSFT Finish Low FROs are High on Profit
and Rolling for Delta is a Double-Edged Sword.
For a list of previous All-Star Trades, please click here.
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This comment and any market data included here were prepared on 7/11/08.
Nicole Wachs contributed to this blog.
Options involve risk and are not suitable for all investors.
Please read Characteristics and Risks of Standardized Options.
While implied volatility represents the consensus of the marketplace as to the future level of stock price volatility or probability of reaching a specific price point there is no guarantee that this forecast will be correct.
Any strategies discussed and examples using actual securities and price data are for educational and illustrative purposes only and do not imply a recommendation or solicitation to buy or sell a particular security or to engage in any particular investment strategy. In reading content in the Community, you may gain ideas about when, where, and how to invest your money. Although you may discover new ideas or rationale that may be compelling, you must ultimately decide whether or not to put your own money at risk. Consider the following when making an investment decision: your financial and tax situation, your risk profile, and transaction costs.
Lawrence G. McMillan has a professional business relationship with TradeKing.
