Thursday, September 27, 2012

Naked Puts Bring Reward and Risk

This article originally appeared on Traders Reserve.

If you�ve ever bought a put option, you know how to make money from falling stocks.

But some of the most-successful traders use puts to profit when a stock is standing still � or even going up.

In fact, instead of using cash (or margin) for every trade, they get paid to make bullish bets with puts.

Call buying isn�t always the best option play for stocks with upside potential. One big reason why is that option buyers lose money four out of five times. Here�s how you can increase your chances of being that one out of five who win consistently.


A Better Way to Boost Your Income

Buying puts can get expensive in a bear market or bear rally. The benefit, however, is twofold: It gives you a way to safely play down-trending stocks, and rough markets can cause premiums to surge.

Yet, you shouldn�t reserve puts for an escape plan when the market goes haywire. Quite the contrary — they can reward you, sometimes even handsomely, during volatile conditions and even those long, boring stretches that happen altogether too frequently.

So, why not buy a call if you think a stock is ultimately going up? Because selling the put means instant gratification in the form of income in your pocket the moment you initiate the trade � money that is yours to keep.


Buy Into Selling Puts

A short put — also known as a naked put, or a put-write — is actually a bullish tool. The advantage to selling puts over buying calls is evident in the math: The odds of winning are significantly increased.

Recent studies show that 80% of long options expire worthless while sellers reap all the benefits of those losing trades. Would you rather take the four-out-of-five shot of making the wrong trade, or join the one out of five who get it right almost every time?

Many professional traders use the short put strategy to buy stocks at prices they want. Nobody wants to pay Google or Apple prices to own shares, but when the stocks pull back — and stocks always pull back — the market helps you to get in at a better price.

But what if you don�t want to buy the stock? Don�t sell puts on stocks you wouldn�t want in your portfolio. You will get taken out of the trade if the stock rises beyond your option�s strike price, and those are the kind of stocks you probably want to own!

This is always the risk with short puts, but it�s hard to call it a �downside� when you end up owning a good stock at a great price. Besides, even if you are assigned to take possession of the shares, you can always sell them on the open market. In fact, you can often get out for a better price and, thus, a profit � and repeat the strategy, if you choose.

Better yet, if the stock goes up and your put gets assigned (i.e., you take delivery of the shares), just sell a covered call against the shares and you�ve found another way to profit in one easy step!

That�s how you �save� a short put position that didn�t go the way you expected. But the odds are on your side that the puts will expire without value for the buyer and you will be out of the trade on expiration day with no further obligation than to enjoy the money you made.


Become a Put Selling Pro

The reason we want to sell the puts is for the premium collection, not to mention that we don�t have to own the underlying stock for the strategy to work. This is a great alternative to a strategy like covered calls, where you lay out a lot of capital upfront and the premium from the short calls pay you to wait for price movement.


How to Trade the Short Put

A) Before getting started you will want to check with your broker whether you can sell naked puts through your account. Because of the risks involved with naked selling many brokers limit these trades to certain customers and certain types of accounts.

1. Locate companies with good products/services, strong earnings, strong technicals and are otherwise fundamentally sound.

2.�Look at the stock�s option chain and locate the strike price closest to where the stock is trading.

3.�Tell your broker that you want to �sell to open� the at-the-money put options. (Pick an expiration date close to the date when you�re initiating the position, such as one to two weeks or months out.)

4.�Keep repeating the strategy for as long as it is working.

5. If the position is working, the put will expire worthless and you are out of the trade. If the position turns against you (i.e., the stock drops by more than the premium you collected), you can buy back your puts at any time before assignment.

One thing option sellers should always keep in mind is that, while your trade is still active, you have absolutely no obligation to remain in it. Most equities have American-style exercise, which means they can be closed or exercised at any time during the life of the trade. (Compare that to European-style exercise, which can only take place on designated days.)

In other words, closing your non-working position before it can be assigned is entirely within your power. If the stock moves quickly, however, you may not get that chance. But if your outlook on the stock changes mid-trade, buy back your options (oftentimes this can be done for cheaper than what you collected at the outset) and move on to the next opportunity.


For more trades, ideas and strategies, visit Traders Reserve.

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