Selling Naked Puts
Cash-Secured Put Options
Selling puts is not a high-risk strategy. It is no more risky than buying stock.
Despite everything you may have heard to the contrary, put selling is a strategy worthy of consideration by almost every investor who buys stock. The very bullish trader who expects to see a large upward change in the stock price represents the single class of investor who should not sell puts.
The so-called "" is told that buying stocks is a good and conservative investment idea.
That investor is also told that selling put options are far too risky. Let's compare two investors who make a trade today:
- The stock buyer pays for the investment in three days when the trade "settles." If the stock price moves higher, the trader earns a profit. If the stock price declines, the stockholder incurs a loss. Very straightforward and easy to understand.
- The put seller collects cash up front when making the sale. He/she puts up collateral (to meet the margin requirement) to guarantee his/her ability to pay for the stock -- if and when it becomes necessary. If the option expires worthless, the collateral is released and the trader keeps the cash premium as the profit.
In other words, the stock buyer pays for shares at the time of the trade and the put seller promises to pay for the stock at a later date. They each have the same risk: If the stock price undergoes a steep decline, each loses money.
This is not a risky proposition for the put seller who understands that he must not sell more than one put for each 100 shares he is willing to own.
Selling too many puts is a risky proposition, but selling too many represents poor risk management skills by the trader. it is not a reflection on the prudence of the strategy.
The put seller agrees (a binding contract) to pay $30 (the strike price) for shares at a later date, but only if he is required to do so. He collects $100 (premium, or option price) for accepting this obligation. If the stock rallies, both earn a profit. However, the stock holder's potential gain is unlimited while the put seller cannot earn more than the $100 premium that he collected.
If the stock price falls, the stockholder always loses money.
For the put seller to have any loss (assuming that the position is held until the options expire):
- The stock price must be below the strike price ($30 in this example) by more than the premium.
EXAMPLE: If the stock is $28, the put seller must pay $30 for the shares. Because they are trading at $28, that is a $200 loss. However, the $100 collected earlier offsets a portion of that loss.
EXAMPLE: If the stock is $29.40, the put seller earns a $40 profit ($100 premium minus $60 loss on stock price).
- The put seller often earns a profit when the stockholder loses money. This is the part of the strategy that makes it so appealing. You sell a put option (taking a bullish stance), the stock price declines, and you still earn a profit!
EXAMPLE: The stock price moves from $34 to $32 and the stockholder loses $200 for every 100 shares owned.
The put seller makes money because the option expires worthless and the profit is $100 (premium collected).
Terminology useful for traders who sell put options
- Assigned an exercise notice. When the owner of any option elects to exercise her rights, then the account of a trader who has a short position in that specific option (i.e., XYZ Jun 20 '14 30 puts) is chosen at random and notified. The notice informs the trader that the option owner exercised an option and that he has been assigned (via a random process) as the person who must honor the terms of the option contract.
In simple terms: When your account is randomly chosen you must buy 100 shares at the strike price for each option assigned to your account.There is no way out of this. By the time you see your account in the morning, the shares have already been purchased.
- Naked put option. A put that is sold unhedged (no offsetting, risk-reducing positions) and the trader does not have enough cash in the account to pay for the stock if it becomes necessary. The trader must borrow that cash from his broker (using margin).
- Cash-secured put. An unhedged put sale, but the trader does have enough cash in the account to but stock, if it becomes necessary.