A common misunderstanding in the minds of rookie traders in the options market is that covered calls are one of the safest option strategies, and selling naked options is one of the riskiest. Although naked-option selling sometimes gets a bad rap, don't be too hasty to dismiss this strategy. There are numerous advantages to naked-option selling that merit your attention. Before we delve too deeply into naked-option selling, let's first recap the objective of most traders. The majority of traders use technical and fundamental analysis, market sentiment, or any other method they deem valuable in an effort to predict where the market is going. This applies whether or not the trader is using the stock or options market to place his bets. However, when we venture into naked-option selling, we adopt a different approach and mentality to trading. We are not so much trying to predict where the market is going to go, but where the market is not going to go.Buying either a call or put option gives the option owner limited risk and unlimited reward for calls, and limited reward for puts. Naked-option selling, on the other hand, brings limited rewards and unlimited risk (for naked calls at least). This begs the question: why would anyone want to place themselves in a position of unlimited or substantial risk? The answer is twofold. First, selling naked options can have a much higher probability of success than buying options. Which do you think is easier, predicting where a stock will go in the future, or predicting where it won't go? It is possible to enter naked-option trades that have greater than 90 percent probability of success. Secondly, although naked-option selling has substantial risk, that risk can be mitigated by proper trade and money-management techniques.Another important point to remember is that option buyers have a right to either buy (call) or sell (put) the stock, and option sellers have an obligation to either buy (put) or sell (call) the stock. The following table has helped me to remember which actions are bullish and which are bearish:Bullish: Long Stock, Long Calls, Short PutsBearish: Short Stock, Long Puts, Short CallsNaked Puts:Selling naked puts is considered a mildly bullish-to-bullish strategy. However, they can also be used in stagnant-market environments. By selling a put option you obligate yourself to buy 100 shares of stock at the strike price. Most traders who use naked puts sell out-of-the-money, short-term put options. There are two primary reasons for selling short-term options. First, the shorter the amount of time we are in the trade, the less exposure we have to a potential adverse move in the stock price. Think of time as risk: the longer you are in the trade, the more there is that can go wrong! Additionally, because of the acceleration of time decay, short-term options decay in value quicker than long-term options. The rationale behind selling out-of-the-money options is simple: out-of-the money options have a higher probability of expiring worthless than do in-the-money options.
An illustration will help us understand the naked-put strategy.
NAKED PUT EXAMPLE
Figure 1
October 31st- After experiencing a precipitous fall in its stock price, NOV has begun to show signs of stability and the potential beginnings of an uptrend. To take advantage of the expected sideways to mildly bullish move in the stock price, we could sell an out-of-the-money November put option. Currently the November 20 put option is trading at $1.00 with a Delta of 15. By selling the 20-strike put, we are essentially betting that the stock won't fall below $20 between now and its November expiration.Max Reward = $1.00Max Risk/ Breakeven = 20 - 1 = $19Probability of Profit = 1 - .15 = .85, or 85
Figure 2
Trade Management IThere are two scenarios that could play out at expiration: either the stock will be above the short-put strike price and our put option will remain out-of-the-money, or the stock will fall below the strike price and our put option will expire in-the-money. If the put option is out-of-the-money at expiration, it will expire worthless, enabling us to keep the premium and net our max reward. If the put option expires in-the-money, it will be automatically exercised and we will have to buy 100 shares at the strike price. Obviously, the best-case scenario is that the put option simply expires worthless. Your success with naked puts, however, is not dependent upon your management of winning trades; rather, it is a direct result of your management of the trades that go against you. You never want to realize your max risk, so let's explore a few techniques on how to manage naked puts that go awry. One technique would be to exit the trade when the stock breaks support. Breaking support would signify that the stock is going into a downtrend; consequently, it may be wise to buyback the put to minimize the loss. A second technique would be to exit when you lose a certain percentage of your max risk. For example, if your max risk is $20, you could exit when you lose 25 percent, or $5. These two techniques are efficient techniques for stopping the bleeding. However, they don't really give you a chance to make back any money you have lost. In next month's article we will discuss a few adjustment strategies that have the capability of turning your losing trade into a profitable one.Probability of ProfitBy using the Greek Delta, we can quantify our probability of profit. One of the definitions of delta is that it measures the probability of an option expiring in-the-money. Using a little arithmetic, we can calculate the probability of an option expiring out-of-the-money. Let's assume stock XYZ is currently at $50 and the 45-strike put option is trading at $1.00 and has a Delta of -40. We know that there is a 40% probability of the put expiring in-the-money, or in other words, there is a 40% probability of stock XYZ residing below 45 at expiration. Let's assume we enter a naked put by shorting the 45-put option. To net our maximum reward, we would want the stock to be above 45 at expiration. Since the probability of the stock being below 45 is 40 percent, then there is a 60 percent (1 - .40) chance of the stock residing above 45 at expiration. This is our probability of success. Since Delta gets smaller as you move further out-of-the-money, selling far out-of-the-money put options has a higher probability of success than selling close to the money options. However, the trade-off to raising the probability of profit is that you don't bring in as much premium. In the example above, the 45-strike put was worth $1.00 and had a Delta of -40. We may have also considered selling the 40-strike put which was trading at $..50 with a Delta of -20. This would have increased our probability of profit to 80 percent (1-.20) and decreased our max profit from $1.00 to $.50.Margin RequirementThe amount of margin required to sell a naked put will vary from broker to broker. Furthermore, knowing the formula is not imperative because your broker will calculate it for you. However, for those that are interested, here is one broker's margin requirement:
1. 25 percent of the underlying market price + the premium - amount out-of-the-money
OR
2. 10 percent of the underlying market price (or strike price for OTM puts) + the premium
The greater of these two formulas will be required in order to enter the trade. Using the above formulas, we can calculate how much margin would be required for a naked put on the United States Oil Fund (USO). Let's assume the USO is currently trading at $53 and we short a November 43-strike put for $.85 credit.
($53 x .25) +($.85 - 10) = $4.10
($43 x .10) +$.85 = $5.15
The second method for calculating the required margin is higher, so that is the amount that would be held by your broker. An $.85 return on an investment of $5.15 is a 16.5 percent return. Not too shabby! Keep in mind the margin requirement may increase if the stock were to drop and get closer to the put strike price. To ensure you are able to maintain your naked put position, make sure to have extra capital available in the event of an adverse move in the stock and increase in margin required.Selling naked puts can serve as an alternative to buying stock or call options in a mildly bullish-to-bullish environment. Naked puts can widen your range of profit as well as increase your probability of profit. At the beginning of the article, I mentioned the erroneous notion that covered calls are "safe" and naked-option selling is "risky." Next month, we will dispel this notion by illustrating the similarities between these two strategies, as well as highlighting a few more adjustment techniques for naked puts, finding potential trade candidates, and implied volatility.
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