5 Key Guidelines for Naked Puts
10/25/2013 8:00 am EST
Most traders will tell you that writing uncovered options is too risky for most of us, but I disagree, says option expert Michael Thomsett of ThomsettOptions.com.
The uncovered call has an unknown degree of risk, based on the possibility that the underlying could rise many points. This isn’t true with the put.
In deciding whether to write uncovered puts, you might discover a goldmine of current income for what really comes down to very limited risks. Four important points can be made about writing uncovered puts:
- Know the real risk. The underlying cannot fall farther than zero; so writing puts on a $25 stock is, in theory, less risky than writing puts on a $50 stock. But even then, zero is not the maximum risk level. To be more accurate, the true exposure has two segments. First, find the tangible book value per share; this, of course, is the equity value without goodwill and other non-physical assets. The initial risk is the difference between the put’s strike and the tangible book value. However, this has to be reduced by the net premium you receive for selling the put. By the way, the tangible value might be understated as well, especially if the company has valuable real estate that’s been depreciated down. The difference between true market value and book value could make your risk even lower. Knowing the risk and identifying low-risk strategies is an essential part of successful option strategies.
- Make sure the put’s premium justifies your exposure. If you are going to write uncovered puts, be sure the premium you get will justify your exposure. This exposure comes in two forms. First is the exposure to exercise and a net loss if the put is exercised. Second is the margin you use up to keep that put open, preventing you from taking other steps in your margin account.
- Be willing to take exercise at the strike. Here’s where a little bit of value investing and fundamental analysis come into the picture. If the put is exercised, is the strike price a reasonable price for this company? Check the P/E and the long-term history of operations, dividends declared and paid, and the stock price. In picking a company and a strike, look for good value; you should be willing to take exercise at that price.
- You can roll forward or cover if you need to avoid exercise. Keep an eye on how the price changes, remembering that an in-the-money put can be exercised at any time. If your put moves toward the money or moves below the strike, you can roll forward and replace the put with a later-expiring one (at the same strike or lower); or you can “cover” the naked put with a later-expiring long put. This is expensive, but all possibilities should be on the table.
- The market risk of uncovered puts is the same as that for covered calls. If you evaluate the consequences of a decline in the stock’s price, you soon realize that the two strategies—covered calls and uncovered puts—contain identical market risks. But there are also two key differences. First, a covered call can be opened at 50% margin in the stock, but an uncovered call requires margin collateral of 100% of the strike, twice as much. Second, if the stock price declines below stock’s net basis (cost of stock minus call premium), you are going to have a loss or you have to wait for price to rebound. But with an uncovered put, you can roll forward to a lower strike to offset that potential loss, without having to worry about losses on your stock
Before you start selling uncovered puts, make an informed judgment about the company. As long as the fundamental trends have been consistent and other indicators strong (P/E and dividend yield, for example), you may decide to rely on price levels and sell believing the put is not likely to move down in the money. Make sure you are willing to take exercise at any time. As long as the price is lower than the strike, exercise is most likely near expiration. That doesn’t mean it will not happen immediately.
By Michael Thomsett of ThomsettOptions.com