How to Trade Naked Put Options (Part 2)

03/26/2010 12:01 am EST

Focus: OPTIONS

Put Sellers

Now that we've gone over the concept of put options from the buyer's point of view (the buyer/owner has the right to sell stock at a certain price), let's consider the benefits of being the seller/writer of put options (which means that you are accepting payment in return for your obligation to buy the stock at a certain price).

Traditionally, a person who thinks XYZ will trade higher might buy 100 shares at the recent price of $16.98. But if you like XYZ you might instead sell (write) the XYZ March 17 Put options. This means you are accepting the obligation to buy XYZ from someone at $17 per share if they decide to sell it to you before the expiration day (the third Friday of the month). 

Ninety-nine percent of the time, when someone buys a put option, they will only exercise it (use their right to sell XYZ to you at $17) when the stock falls below the strike price (of $17).

If the XYZ March 17 puts are trading at $1 - $1.05, then someone is willing to pay you $100 for the right to sell 100 shares of XYZ to you at $17 at some point before the expiration day.

Benefits of Short Puts

First off, if you are already considering the purchase of XYZ at $16.98, then you wouldn't mind if someone first paid you $100 for the put option, and then sold you XYZ for $17 (probably because it went down).

The math is simple. If you buy 100 shares of XYZ at $17 after someone has paid you $100 for selling them the put option, you have really purchased 100 shares of XYZ for $16 a share (not including trading expenses).

Intrinsic Versus Extrinsic Value

In our example, the strike price is $17. Therefore, the option is considered to be in the money by the amount that XYZ is trading under $17. 

So if XYZ is at $16.50, the XYZ March 17 puts are 50 cents in the money. If XYZ is at $14, the March 17 puts are $3 in the money, and so on.

The amount by which an option is in the money is referred to as "intrinsic value."

To understand the advantages of selling options, it's important to understand "extrinsic value," aka "time value."

Options lose their extrinsic value as time passes. The extrinsic value of an option's price might account for some of an option's price, part of an option's price, or all of an option's price. Therefore, an option seller/writer benefits from the deterioration of extrinsic value due to time passing, a process known as time decay.

Extrinsic (Time) Value = Option Price - Amount Option Is in the Money

If XYZ is at $16.98, that means the March 17 put is two cents in the money. Since the March 17 put costs $1 per put option, we know that that put option has 98 cents of extrinsic value ($1 put option - two cents intrinsic value = 98 cents extrinsic value).

When you sell/write an option, you want to do so with an option that has lots of extrinsic value because as the process known as time decay happens, the seller of the put option profits. 

Key Point: Time decay benefits the seller/writer of an option whether the stock and option moves up, down or sideways. Either way, time decay is happening.

After you sell/write a put option, there are three possible outcomes:

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Outcome Number One: The Stock Moves Up

If this happens, the put option that you have sold/written will lose value. And this is a good thing because when you sell/write a put option to open, you have essentially sold short a put option. And when you sell short something that loses value, you are making money. 

For example, if you sell something at $1 and buy it back at 25 cents, you make a profit of 75 cents. So if the stock moves higher, causing the put option you have sold at $1 to move lower to 25 cents, you can buy that put option back. You would enter the order as a "buy to close." If you purchase the put option to close, you will have closed out the position and you will no longer have an obligation to anyone to buy XYZ at $17 per share. The trade is done and the contract ceases to exist.

In this scenario, you have two things working in your favor: XYZ is moving higher, and time is passing, both of which cause the put option you have sold to lose value.

There is one other bonus that most people don't think about. Because the stock started moving higher (or stopped tanking) people became less fearful, causing the put option to get even cheaper. As we've just said, fear is what causes people's willingness to pay even higher prices to buy options. When the put option you have sold gets cheaper, you can also choose to not make any closing put option trades. 

If XYZ is above $17 a share when the March 17 put option expires, the put option will have expired worthless, and you will no longer have an obligation to anyone to buy XYZ. 

But if the stock moves back down below $17, someone may exercise their put option, and therefore sell you XYZ at $17.
Remember, your break-even price of XYZ is now $16 ($17 purchase price - $1 premium received for the put option you sold/wrote).

Outcome Number Two: The Stock Moves Down

If this happens, the put option that you have sold/written will increase in value. 

Now this is different than when you sell short a stock that moves higher because, in this case of being the seller/writer of a put option, your position is not losing value.

Instead, you can be sure that someone who owns the XYZ March 17 puts (who remains anonymous) would exercise their right to sell XYZ to you at $17. 

When this happens, you will check your stock account and you will notice that you have automatically bought 100 shares of XYZ at $17 (even though it is trading in the market at a price lower than $17).

You shouldn't have a problem with this scenario because you were willing to buy XYZ when it was trading at $16.98 anyway, right? Now you will have bought it at $17 after receiving $100 for the put option you sold. 

This means that, although you were going to spend $1,698 on XYZ stock, you have now spent $1,600 ($1,700 when someone exercised their put minus the $100 you received from the person who bought the put option you sold).

Outcome Number Three: The Stock Moves Sideways

Chances are the stock won't be at exactly $16.98, but for the sake of the explanation, since XYZ is at $16.98, the put option will probably expire worthless. 

This means that you collected $100, and if you like, you can repeat this process again and again, thus collecting more premium each month. 

Special Note: When selling/writing naked puts, it makes sense to sell the put option that expires within 45 days and the one that has the closest strike price. 

In my XYZ example, the stock was at $16.98, so the closest strike price was the March 17 put. Since XYZ was two cents lower than $17, it was two cents in the money. 

If you still find this strategy confusing, it pays to read up on it more. If you have never done this before, ask for some help from your broker, and be sure to understand the cash requirements (in the case that the put option is exercised and you end up buying the stock) before proceeding.

Read Part 1

By Chris Rowe of TheTrendRider.com

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