Selling naked puts (sometimes called short straight puts) is an excellent strategy for buying stock at a discounted price. But this strategy is inherently risky and needs to be traded with care, since the potential losses can be huge. When you sell a put on a stock, what you’re essentially doing is setting yourself up to buy the stock at a price that’s more beneficial to you. This strategy should only be used to purchase stock that you want to own.
Naked Put Example
Let’s say Google (GOOG) is trading at $50, you could sell a $40 put, which means that if GOOG falls to $40, you’ll be required to buy 100 shares of Google stock, which will cost you $4,000.
But when you sell a put you’ll receive an options premium of $200. Therefore, your net cost for buying the stock at $40 is decreased by the income from the sale of your put. So instead of paying $40 per share, you’ll effectively be paying $38.
Let’s say it takes six months for GOOG stock to reach $40, if you sell a put each month; your net cost for buying the stock will be much lower than it otherwise would be.
The only drawback to this strategy is that most brokers require quite a high margin to execute it. The reason it’s called a naked put is because it doesn’t have the protection from a major crash that credit spreads have.
In the event that the stock does crash, your broker will want to ensure that you have enough money to buy the stock at the strike price. The formula differs from broker to broker, but the margin requirement usually work out to be around 12% of the full purchase price of the stock, should it get exercised.
How to Sell Naked Puts
The first thing you need to do is pick a stock that’s currently trending upwards or sideways. Make sure that there are no earnings or dividend dates within the next month.
Next, use an options probability calculator, your broker should have one in their tool-set. This will tell you what the chances are that your option will get exercised. You need to set the range to around 5% or 10%. This means you’re looking for an option that has a very low chance of being exercised. If your broker doesn’t have an options probability calculator sign-up for a free account at optionsXpress and use theirs.
Now pick an expiration date that is no more than 30 days out – you want your option to expire so that you can sell another one! Make sure that you have enough money in your account to cover the margin. If you’re not sure how much margin is required, carry out a paper trade in your virtual account first.
Now only two things can happen, your put can either be exercised or it’ll expire worthless. Naturally you don’t want the option to be exercised, you want it to expire, at which point you can sell another one for the following month!
If you do get exercised, don’t panic. If you’ve chosen your stock correctly you’ll have bought a stock that’s severely undervalued. So you can either sell the stock immediately to cover your margin, or if you can afford it, sell covered calls on the stock that you now own. This way, you can even further discount the cost of the stock and sell it at a profit when the price recovers.
If you don’t want to buy the underlying stock, and are using this strategy for income, you should probably be trading credit spreads instead. If your trade does go badly wrong DON’T WAIT for the option to be exercised, you don’t want to be in a position where you’re forced to buy the stock, unless you really want to.
Buy the option back before it goes in the money and sell another naked put at a lower strike price. You’ll need to use a stop loss to exercise this trade, which you put in place as soon as you sell your first put. This way, you should come out even or only slightly under.
Selling naked puts is a great trading strategy to buy stock at a discounted price, but only if you have enough money to cover the margin requirements. If you don’t have enough money to cover the margin, then selling credit spreads is very nearly as profitable and even safer.