How to Trade Naked Put Options (Part 1)

03/25/2010 12:01 am EST

Focus: OPTIONS

I'm going to show you how to get paid to buy stocks at a price you want. Instead of purchasing the stock, you can have someone actually pay you for a contract that gives them the right to sell your favorite stock.

This strategy will allow you to collect on overpriced stock option premiums and/or buy your stock at a discount. It's a strategy called selling naked puts. 

Selling Naked Puts

When you "sell to open" put options, which is also known as "selling naked" because you don't own the underlying shares, you are taking on the same risk that you would when you buy the stock outright (minus the amount of money that you received for selling the put option, which really means you are taking on even less risk than outright stock ownership).

So if someone pays you $2 for a put option that you sell to them, this put option gives the right (but not the obligation) to sell you XYZ stock at $50. So, the risk you are taking in this position is the same risk you would have taken if you bought XYZ at $50, minus the $2 that you're getting paid ($50 - $2 = $48).

In fact, the risk and reward are exactly the same as when you sell covered calls on a stock position you own. If you understand the covered call strategy (i.e., selling call options against your long shares), then you should have no problem understanding the risk and reward of naked puts.

If you are comfortable with covered calls, then you are comfortable with naked puts. The only difference is that there is less cash outlay in naked puts. Just like covered calls, the profit is limited when you sell a naked put option.

When you buy a stock, you only profit when the stock moves higher. When you sell the naked put, you can profit when the stock moves up, sideways, or even down by a small amount. So, when you sell naked puts, your profit potential is limited, but it is more likely that you make a profit.

However, if you sell/write a naked put option and it's exercised (i.e., the put owner decides to exercise his right to "put" shares to you at the strike price of the option), you'll be obligated to buy the stock, in which case you'll have unlimited upside potential.

The Mechanics of Selling Naked Puts

If you buy 100 shares of XYZ at $30, you'll pay $3,000. Or you can have someone pay you $200 for their right to sell you 100 shares XYZ at $30. (This would actually give you a cost basis or breakeven point of $28.)

Put Buyers

One XYZ March 30 put option allows the owner of the put option to sell 100 shares of XYZ at $30 per share at any point between now and the third Friday of March, which is the last trading day before the option expires. (Find out why options don't expire on Fridays like most people think.)

The owner of a put owns the right to sell a stock at a certain price, and the seller (writer) of the put promises to buy a stock at a certain price if the owner of the put decides that's what he wants to do.

Sometimes put options are used as "insurance" against a possible decline in a stock.

If Bob owns XYZ stock, which is at $30, but is afraid the stock might drop significantly, he may purchase the right to sell XYZ at $30 by buying a put option.

Let's say Bob purchased the put option for $1.10. Since options prices are quoted per share, and an options contract represents 100 shares, Bob is paying $110 for one contract.

In other words, he gave up $110 for the peace of mind of knowing that, if XYZ drops to $15, he will exercise his right to sell XYZ at $30 (even though it trades in the market for $15). So Bob paid $110 for that insurance.

But what if Bob was incredibly frightened by the stock market because overseas markets dropped by 8% overnight? Well, he might be willing to pay $2 per put option ($200 instead of $110).

There is a whole market full of people like Bob out there. This explains how options become more expensive in a scary market. And you want to sell options when prices are high and buy options when they're low.

Continued tomorrow in Part 2…

By Chris Rowe of TheTrendRider.com

Related Articles on OPTIONS