Debunking Myths About Naked Puts

06/13/2014 8:00 am EST

Focus: OPTIONS

A lot of misconceptions have been told about naked puts, and Ryan Brennan of Optionstrategist.com explains what they really are and what they’re good for.

Do you sell naked puts? If not, you may want to consider doing so. People often stay away from uncovered put writing because they hear that it is "too risky" or that it doesn't have a sufficient risk-reward. The truth is that put-selling, when secured by cash, is actually less risky than owning stock outright and can outperform the broad market over time. The following article debunks myths surrounding put-writing and explains some of the benefits of this simple-yet-effective strategy.

Put-Selling is Conservative
"The basic concept of option writing is a proven investment technique that is generally considered to be conservative. It can be implemented as 'covered call writing' or, alternatively, 'naked put writing'—which is the equivalent strategy to covered call writing."

Put-Selling Can Outperform the Market
"The Chicago Board Option Exchange (CBOE) has created certain benchmark indices so that investors can compare covered call writing (BXM), naked put selling (PUT), and the performance of the S&P 500 Index (SPX). The chart below compares these indices, with all three aligned on June 1, 1988.

chart
Click to Enlarge

It is clear from the graph above that naked put writing (PUT) is the superior performer of these benchmark indices. For this reason, naked put writing is the preferred option-writing strategy that we employ" in our newsletter services.

Positions Can Be Hedged
One of the main arguments against put-selling is that the drawdowns can be large in severe market downturns. One way to avoid these drawdowns would be to hedge each individual position or the entire put-sale portfolio. For example, in our publication The Daily Strategist newsletter, we attempt to offset the market risk that is inherent to option writing by continually hedging our portfolio with dynamic volatility-based modern portfolio protection techniques.

The Odds Can Be in Your Favor
Out-of-the-money put-selling win rates based on statistical analysis such as probability and expected return can be quite impressive. For example, The Daily Strategist has produced combined 89.4% winners in its index and equity naked put-selling/covered-writing trades since the newsletter started recommending them in May of 2007.

In summary, contrary to what may be popular opinion, naked-put writing is a conservative strategy that has the potential to outperform the broad market over time. When implemented correctly, the strategy can have high rates of success and can also be hedged against large stock market drawdowns.

By Ryan Brennan of Optionstrategist.com

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