Finding the &quot;Write&quot; Naked Put Trade

04/05/2010 11:18 am EST

Focus: OPTIONS

The following is an excerpt from Naked Puts: Power Strategies for Consistent Profits, by Ernie Zerenner and Michael Chupka.

Overvalued/Undervalued Options

Another important aspect an investor needs to assess before selling a naked put is if the option is overvalued or undervalued. The previous sections have discussed the criteria one should use when analyzing the risk/reward ratios for a naked put trade. In this strategy, we are selling a contract to the market. Even if the premium offered matches our personal risk/reward tolerance, we still want to receive a good value for the contract we are selling. If you were planning on selling your house or your car, would you not try to receive better than market value for your property? Of course you would, and you should expect nothing less when you are selling a put contract.

In chapter two, we walked you through the concepts of the Black-Scholes value of an option and the values used in the Black-Scholes pricing model. The Black-Scholes value is the theoretical value for a specific option. As mentioned before, option contracts typically do not trade on the market at the theoretical price. The simplest way to determine if an option is overvalued or undervalued is to use the Black-Scholes Ratio. This ratio compares the actual trading price of the option to its theoretical worth:

Black-Scholes Ratio = Trading Price of the Option/Theoretical Worth

If the option we are researching has a Black-Scholes Ratio equal to 1, the trading price of the option is equal to its theoretical worth. An option with a Black-Scholes Ratio of 1.25 means that the trading price of the option is 25% higher than its theoretical worth (25% overvalued). An option with a Black-Scholes Ratio of 0.75 means that the trading price of the option is 25% less than its theoretical value (25% undervalued).

As option sellers, we want to look for overvalued options. We want to get more bang for our buck, so to speak. We want to collect more premium than the option is theoretically worth. If you are a Group 1 investor and have already picked the stock and the target price to purchase shares of stock, this criterion does not necessarily apply. You are going to sell the strike that is closest to the target price you selected to buy shares of stock. Investors in Group 2 will want to look for put options that have a Black-Scholes Ratio greater than 1 to find only those options that are overvalued.

The trading tip in the volatility discussion of chapter two pointed out that there are many different time frames that can be used to measure volatility. As volatility is one of the main components of the Black-Scholes equation, there are also different Black-Scholes values for an option depending on the measure of volatility that is used.

Naked put investors typically focus on the option that has less than 45 days to expiration to maximize the annualized return. Therefore, it is best to use the 50-day volatility when calculating the Black-Scholes value to compare against the trading price of the option, or to use the stock’s implied volatility index (SIV) value, which is the average implied volatility of the ITM and OTM calls and puts of the near-term expiration months. The 50-day volatility and the SIV are better indicators to evaluate the near-term options compared to the longer-term volatility measures over 100, 200, or 250 days.

Another method investors use to evaluate if the option is overvalued or undervalued is to compare the option’s implied volatility to the underlying stock’s historical volatility. The historical volatility reflects the past price fluctuations of the stock itself. The option’s implied volatility measures the market’s future expectation of the stock’s volatility pending the outcome of any near-term events. The implied volatility ratio is the ratio of the implied volatility (the future expectation of volatility) divided by the historical volatility (the past volatility of the stock). If the implied volatility ratio is greater than one, many investors surmise that the option is overvalued because the future expectation of the volatility is greater than the past volatility. In contrast, if the implied volatility ratio is less than one, the future expectation of the volatility is less than the past volatility; therefore, the option is undervalued. Naked put investors want to find overvalued options, so we would look for an implied volatility ratio greater than one.

Either the Black-Scholes Ratio or the implied volatility ratio can be used to help determine if the option is overvalued or undervalued. An investor can even use both criteria when screening for overvalued options, though it is not necessary.

NEXT: How to Evaluate Risk/Reward Ratios

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Evaluating the Risk/Reward Ratios

When writing naked puts, just like any other form of investment, one has to be aware of the realistic expectations when searching for or placing a trade. In this chapter, we have outlined for you the generalized expectations for the risk/reward tolerance when placing a conservative, moderate, or aggressive naked put trade based on the average stock price of all optionable stocks and the average volatility on those stocks. All stocks do not have the same price, nor do they have the same volatility. In addition, many optionable stocks will have upcoming events that will inflate the price of the near-term puts, which is reflected in the implied volatility. This is why we sometimes define implied volatility as the double-edged sword.

Options that have a higher implied volatility also have a higher potential percent naked yield and a greater percent to break even because of the inflated premium. This works to the advantage of a naked put writer, as these trades will offer a better risk/reward ratio. However, if the implied volatility is too high, the potential risk for the trade might not outweigh the benefit of the higher premium. If you stumble across a naked put position that is offering a return and protection that seem too good to be true, then it probably is. The option is highly overvalued for a reason, most likely because of the risk involved with trading that option. When you find a trade of this kind, the first thing you should do is check the implied volatility for the option. Most likely, the implied volatility will be well above twice the average of all options across the market. The increased implied volatility will alert you that there is an upcoming event that may cause a drastic shift in the underlying stock price. You can then research the company news to determine the nature of the upcoming event, and from that research, decide if the risk for the trade is within your personal threshold.

Liquidity and the Greeks

In chapter two, we outlined some general rules of thumb regarding the option volume and the open interest. The suggested values will help filter out thinly traded options that may have a deflated premium or may cause problems when the investor is attempting to close or adjust the trade. Many investors already have their own minimum requirements for volume and open interest set when they plan to enter a trade. Just as some stock investors will not trade a stock if the average volume is less than 500,000 shares per day, many experienced options investors will not sell or buy an option if the daily volume is less than 50, 100, or even 1,000 contracts. The same holds true for the open interest.

Through the years, we have also talked with dozens of “bargain hunters.” These investors will screen specifically for options with little or no volume and low open interest. Their concept is that they can place a limit order for the option and get a better price from the market maker, as there is no interest on the particular option. This type of investing is more aggressive and has a few drawbacks. First, if the option has not traded in some time, the listed price might not have been updated recently. This means that the limit order might never get filled, or worse, if you placed the trade as a market order you might receive a premium that is vastly lower from the listed price. Second, if there is little or no liquidity you may have a harder time trying to exit the position if the stock starts to move against you.

As you become a more active options investor, you will develop your own limitations and requirements for option volume and open interest based on the success rate of your trades. If you are just starting out and you are looking to place your first trade, we suggest following the recommendations in chapter two: Screen for positions that have a volume that is at least five times greater than the number of contracts you are hoping to sell, and an open interest at least ten times greater than the number of contracts you are hoping to sell.

Knowledge of the Greeks is essential to any options trader regardless of the options strategy you are trading. The Greeks give investors advanced insight into how the option premiums may adjust with changes in the stock price, time decay, volatility, or fluctuations in the interest rate. Even though the delta and theta values are important to know when entering or monitoring a naked put trade, there are no real guidelines one should follow when screening for positions.

If you are selling a naked put that is three or more strikes OTM, the delta for the option will be relatively low. The deeper OTM put options will have a delta closer to zero. ATM put options, those closest to the stock price, will have a delta close to -.50. It is important to be aware of the delta so you can gauge the value the option will increase or decrease with changes in the stock price.

This concept also applies to theta. Understanding how much value the option will lose as time passes is important when monitoring the position, but it is not the most essential criteria to screen when looking for potential trades. Once again, as you become a more active options investor, you will develop your own ranges for delta and theta based on your experience from previous trades.

By Ernie Zerenner and Michael Chupka, authors, Naked Puts: Power Strategies for Consistent Profits