Selling Naked Put Options


When I played around in the stock market years ago, I would have loved selling naked put options. The problem at the time was that to be approved for naked option writing (selling), you had to have substantial experience and a high net worth. It may be the same now with most brokers. In general it is considered too risky for the average investor, and it is if you sell naked call options.

A call option is a contract that gives the holder the right, but not the obligation, to buy 100 shares of a stock at a given price (the strike price) by a given date (the third Friday of the expiration month). Pepsico, Inc (PEP), for example, closed at $64.68 today (12/07/10), and January $67.50 call options are selling for 31 cents per share, or $31 per contract (which covers 100 shares). Now, let's say you own 500 shares of Pepsi, which you bought for $45 years ago. You look at the history of the stock and see that it's been bouncing around and is unlikely to be higher than $67.50 in six weeks, when the January options expire. So you sell 5 option contracts (you never see a contract--it is all just a mouse click in your online account), netting about $145 ($31 times 5 minus commission).

These are "covered options," because your stock covers the possibility of being forced to sell 500 shares at $67.50. These are also called "out of the money" options, because if the price of the stock remains the same there is no intrinsic value in the option at expiration. It has to move for the options to be worth something in the end. Now, let's say that the price goes to $82.50. The option will then be "in the money" and your stock will be "called away" at $67.50, which isn't so bad, really, since you sold at a profit, and perhaps you generated extra income many times by selling options before you had to sell the stock.

But what if you just sold those options without owning the stock. Then they are called "naked options," because there is no stock covering them. You would make $145 selling the options--and maybe you have made money like this several times before since most options expire worthless--but in this case you would be forced to buy 500 shares at $82.50 in order to fulfill your contract to sell them at $67.50, so you would lose $7,500. When you are "naked" on call options your losses are theoretically unlimited. Pepsi could make a big announcement and jump to $170 per share, and you would lose $51,250. But before you start thinking it's just crazy to sell naked options, you should know that there's a safer way to do it. It is to choose good stocks and sell put options on them.

A put option is a contract that gives the holder the right, but not the obligation, to sell 100 shares of a stock at a given price (the strike price) by a given date (the third Friday of the expiration month). To use the common explanation, it gives the holder the right to "put" it to you. If you are paying attention, you should have noticed that buyers of call options are hoping the underlying stock price goes up. In the first example, if the stock went to $82.50 each of those $31 options was worth $1,500 since they cover 100 shares and the holder can buy at $67.50. A put option is the opposite--a bet that the price will go down.

Now why would you want to sell naked put options? There are two reasons--two ways to increase your stock trading profits using the following strategy. The first is to simply make money from selling the options. If you stick to out-of-the-money options most of them will expire worthless and you'll just collect the option proceeds month after month as you sell. The other way they can make you more money by lowering your cost to buy stocks you like and want to own.

For example, today (12/07/10) the stock of Navios Maritime Holdings Inc. (NM), a shipping company, closed at 5.46. Let's say you take a closer look and see that the 52-week price range has been between 4.38 and 7.55, and the current PE is 5.98. You like what you see and are inclined to just buy 1,000 shares, which with a $5 discount-broker commission would cost you $5,465. But what if there was a way to make money from the stock without owning it, or to buy it cheaper than that?

There is. As of today the bid for the January 5 put is $ 0.15, or $15 per contract. Lets say you just sell 10 contracts for $150, netting about $140 after the commission. $140 is deposited into your account and you wait to see what happens in the next six weeks prior to the options expiration date (January 21--the third Friday of the month). If the stock price stays above $5 nothing happens and you keep the $140. What if the stock drops 15% to $4.64. The stock will be "put" to you, meaning you'll be forced to buy 1,000 shares at $5. Of course, you still have the $140, so your real cost after another $5 commission is just $4,855.

Yes, your 1,000 shares are only worth $4,640 at the current price, but notice that you still paid $610 less than if you had simply bought the shares when you first though of it at $5.46. So with this strategy you either made $140 without owning a thing, or you bought a stock you really liked for a lot less money. Also notice that the most you can lose is $4,855 if the price goes to zero--nasty, but still less than if you had bought and held the stock the traditional way.

How Much Can You Make?

How much you can make depends on a lot of factors, most of which we are not going to look at here. But let's assume that in order to be approved by your broker for selling naked put options, you need to maintain a balance of 100% of the potential purchases you may have put to you. If you had $40,000 in your account and found eight deals like the one in the example (similar in both stock and option prices), and all of the puts you sold expired worthless (common, by the way), you would be making about $1,120 in six weeks. Every time they expire you sell more options that are a month or two out, perhaps averaging around that $750 per month in income from the sales. That amounts to $9,000 annually for having your $40,000 sit in that account--a return of 22.5%.

Naturally you will sometimes be forced to buy stocks of course, so you might use this as a way to buy them more cheaply over time, as they are put to you, and make money with any excess cash by using it to cover more sales of put options. If the stocks you are forced to buy bounce back you can sell at a profit and start the process over again. The basic idea here is that the worst you can do is pay less for stocks which you have already decided you would like to own.

Ways to Make More | Related Opportunities | Tips

Options have horrible spreads, so when selling you might try to get between the market-maker's bid and ask to net more. For example, the oil company Vaalco Energy Inc. (EGY), closed at 7.51 today. It's a solid business with a PE (price/earnings) ratio of about 13, and the January 7.50 put has a bid of .35 ($35 per contract). But the "ask" price is .65 per share. There is enough activity in these options that if you undercut the market makers and offer to sell 10 contracts for .50 you should find a buyer. That represents $150 more in your pocket versus just selling "at the market."

If you are more interested in simply getting your stocks cheaper than in making the extra cash, sell in-the-money options. For example, today Microsoft Corporation (MSFT) closed at 26.87. It has a PE of only 11, and Bill gates is still around, so what if you just want to get it at a discount? You could sell 5 of the DEC 27 put at 0.40, and you'll have $190 deposited into your account after commissions. In ten days the option expires, and if the price is still under $27, you'll be forced to buy 500 shares at that price, or $13,500 total. That's $65 more than if you just bought it to start with, but remember that you collected $190, so you really paid $135 less.

Qualifications / Requirements

You will have to check with your broker about the requirements for getting approved for naked option writing. Most people will not qualify, even if they plan to use only the safer strategies.

First Steps

Get an application for selling uncovered options from your stock broker and fill it out.

Resources - Great resource for stock prices, information, and you can just click the options button to get lists of all the options you can sell on a given stock. - This is one of the cheaper brokers, and I like their service.

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