Write Naked Puts But Keep Your Shirt

04/09/2012 12:15 pm EST

Focus: OPTIONS

Dan Passarelli

Founder, Market Taker Mentoring, LLC

Writing naked puts under the proper conditions can allow traders to earn considerable income, explains Dan Passarelli, but this strategy is also a valid way to buy stocks at a discount.

If you want to learn to trade options, here’s a really useful option strategy that all traders should know. Let’s take a look at an option strategy that involves the selling of a put, often referred to as an “uncovered put write,” or “naked put write.” A naked put write is when a trader sells a put that is not part of a spread. This strategy is generally considered to be a bullish-to-neutral strategy.

The maximum profit is the premium received for the put. The maximum profit is achieved when the underlying stock is greater than or equal to the strike price of the sold put. Though this allows for a lot of room for error (the stock can be anywhere above the strike at expiration), note that the maximum loss is unlimited and occurs when the price of the underlying stock is less than the strike price of the sold put less the premium received.

Executing this trade in the right situation is essential. To calculate breakeven, subtract the premium received from the sold put’s strike price.

Naked Put Writing Example

For our example, we will use Apple (AAPL) and will assume the stock is trading around $625 a share. A trader sells the April 615 put, which carries a bid price of $10.00 (rounded to make the math a bit easier).

Should AAPL stock be trading above $615 a share at expiration, the April 615 contract will expire worthless and the trader will keep the premium collected. (Do not forget to remove any commissions the trader may pay from the equation.) All is good, right? Well, what if the stock falls?

If AAPL falls to, say, $600 at expiration, the put would expire in the money and would have to be purchased back to avoid assignment. This could cost the trader a rather hefty sum. Assigning values, our investor collected $10 in premium. The 615 put expired with $15 in intrinsic value. The trader loses the $15, less the $10 premium collected, and this results in a loss of $5, or $500 of actual cash.

Why Sell Naked Puts?

We have already discussed the profit potential of selling naked puts, but there is another reason to do so: owning the stock. Selling naked puts is a good way to purchase at a specific price by choosing a strike near said target price.

Should the stock price drop below the put strike and the puts are assigned, the trader buys the stock at the strike price minus the option premium received. Again, should the put not reach the strike price, the premium is pocketed at expiration.

By Dan Passarelli of MarketTaker.com

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