Selling Puts (Naked Put) Strategy

Selling puts is a good strategy to use for generating income and potentially getting paid to own a stock. This can be a bit of a risky strategy though if you don't take appropriate precautions. I won't use this strategy unless I am prepared to own the stock.

It is also called a naked put strategy because I am not protected or covered in the event of the stock goes against me. As should be apparent from the above P&L graph, there is a lot more downside risk than upside profit potential.

Outlook/Analysis

Selling puts is a bullish strategy, much like the long call strategy with two key differences.

  1. I only need to be somewhat bullish to use this strategy.
  2. profit is limited and the risk is not defined.

I use the term 'undefined' because risk isn't quite unlimited. If I sell someone the right to sell me the stock at $20, then my risk is that the stock goes to $0 and I lose $20/share times 100 shares for every contract you sold. However, it's rare that this happens. A stock may lose a lot of its value but likely won't go to $0.

If I am bullish longer term on a stock but I don't want to purchase it at the current market price, I might sell a put with a strike price near the price I would be willing to buy the stock for. I would collect a premium for selling the put. If I was assigned at some point, my cost basis of the stock would be the strike price minus the premium I collected when I sold the put.

Trade Entry


Selecting the right stock

When selling puts, I usually try to find a stock or ETF that I am bullish on and wouldn't mind owning. I keep a watchlist of stocks that are in bullish trends, bearish trends and sideways trends.

For this example, I've selected Potash (POT). POT has participated in the recent down cycle but has begun to establish a new bullish trend. I wouldn't mind owning POT at somewhere near current prices.

POT Selling Puts example

Timing the entry

As with many trading strategies, timing the entry is an important aspect.

POT Selling Puts - Technical entry

When selling puts, I like to make sure that I am near a support bounce.

The ideal entry is to catch it right on the bounce, however confirmation is important as well. For me, this entry is still acceptable as it is early enough in the move.






Selecting the right options

I'll want to select a put strike price below the current price. How far below is determined by a number of factors.

  • What price do I consider a good price to own the stock?
  • Where is recent support?
  • What is the premium I can collect?

I usually try to find the next lowest strike price but I also like to have it near a support level. I do this because it tends to increase my chances of a successful trade since the stock is likely not to fall below support.

No... technical analysis, support and resistance aren't guarantees. They are simply a means to increase the odds and provide a means of determining when my initial assumptions are wrong.

I will also select an option month about 4-6 weeks out. When selling puts, I don't like to go too far out in time as too much can happen in the future. If I choose less than 4 weeks, the premium is usually too small to justify the trade.

For this example, I'll choose the March 80 put, currently selling for $5.75. I chose this strike price because there is a measure of support at about $76 and by selling the $80 put for $5.75, my cost basis in the stock would be about $74.25. That way, if I were assigned on the puts, and POT was to break down below previous support, I could still sell the POT shares at a small profit.

Analyzing risk/reward

Selling Puts P&L graph

To understand the risk and reward, let's take a look at some possible outcomes.
  1. POT continues to move up and the put I sold decreases in value and/or becomes worthless
  2. POT moves down to $79 on expiration, I get assigned and my cost basis on the stock is $74.25
  3. POT moves down to $50, I get assigned and I'm now facing a $24.25 loss on the position (per share)
The first outcome represents perhaps the best case scenario. I get to keep the entire $5.75 I collected in premium... or at least most of it if I close out early.

The last outcome represents a worst case scenario. In reality, I would have some sort of stop loss in place to prevent me from either getting assigned in the even the stock moves down, or if I have been assigned, the stop loss can protect me from a further loss.

In a trade like this, I'd likely make a determination that if POT fell below $75 either before or after I was assigned, I'll exit. If this happens after assignment, I'll still make $.75 on the trade if I got out right at $75.

Let's take a look at my projected loss if I am still short the $80 put when POT moves down to $75. Currently, the delta of the $80 put is -.37, which means if POT moves down approximately $9 to $75, it will cost me approximately $3.33 more to buy it back.

Why $3.33? With a delta of -.37, I can expect my put to increase in price $.37 for every $1 decrease in the stock price of POT. So, $9 * .37 = $3.33 increase.

If my potential reward is $5.75 and my potential risk is $3.33, then my reward/risk ratio is 1.7:1... almost 2:1.  Not too bad.

Determining my reward is a little trickier if I assume I'll get assigned. Once I own the stock, many things can happen. POT would continue to make higher highs and higher lows in a bullish up trend and therefore increases in value. I may choose to sell covered calls on my newly acquired shares of POT, which increase my upside.

Placing the order

For selling puts, many brokers require you to be approved for level 4 trading authority. Level 4 gives you the right to trade naked short calls & puts. Before you begin selling puts, you may want to check with your broker to make sure you are approved.

Let's move now to determining our position size. There are two things to keep in mind.

The first is the expected max loss using my exit plan outlined above. I projected a loss of $3.33 as the loss amount if POT should move down to $75. I can use this to determine my position size. If I was willing to risk $1000 on this trade, then I could sell $1000/(3.33 x 100) =3 contracts.

The second thing to keep in mind is the margin required. When I place an order to sell 1 contract of the $80 put as a naked order, I am potentially risking the entire $80 x 100 for every contract sold... in this case $8000.

My broker will hold some of that amount as margin that I can't use for anything else. In IRA accounts, I am required to put up the full amount as if I bought the shares outright. I may reach my tolerance or ability to set aside sufficient margin before I reach the calculated position size arrived at earlier.

I will usually go with the lesser of these two.

For selling puts, some online brokers designate opening orders differently than closing orders. I may have to place the order as 'sell to open' 12 contracts of the March 80 put for an ask price of $5.75. Later, I would close the position by issuing a 'buy to close' x contracts of the March 25 put for an ask price of $x.

Trade Exit

Earlier, I talked about some of the exits I might consider. When selling puts, I will usually have a plan to exit in the following circumstances.

  • When I can lock in 80% of the credit I received initially
  • When it cost me a percentage more than my initial credit to close.
  • When my technical indications suggest I should no longer be bullish on the stock or ETF

In the previous section I went into some detail on how I selected my stop loss based on a break of a support level. I may alternatively choose to set an absolute percentage like 150% of my initial credit as an exit. In this case, if I received an initial credit of $5.75, I may choose to exit if it cost more than $8.62 to buy back the put.

If I am using percentages for both situations, I can simply place a OCO (one cancels other) order to ensure either one or the other condition is automatically handled.

Check with your broker to see if they support this kind of order before you begin selling puts.

Summary

Selling puts is a strategy I would use when I would like to own a stock but at a lower cost basis than the current market price. I get paid to take that risk and in many instances, I keep the credit without ever having to buy the stock. However, I would NEVER sell a naked put on a stock or ETF unless I was willing to own it.

Outlook: Neutral to near term bullish
Max profit: Limited to credit received
Max Loss: Ultimately, the strike price sold minus the credit received. Practically - can be limited with stop loss
Net Position: Short
Time decay effect: Works in your favor



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