It’s fair to say that the strategy dominating my option trade suggestions of late is the short put, also known as selling puts or the naked put. I attribute its appeal to three factors: It profits from time decay, has a high probability of profit and it presents a more conservative alternative to buying call options.
A few of my recent short put suggestions can be found in this article about oil prices and this one on refiner Tesoro (NYSE:TSO).
Regardless of the strategy employed, generating consistent profits relies heavily on not only having a quality trading plan, but also possessing the discipline to follow it. With that in mind, let’s explore a few prudent techniques for managing short puts.
The exit plan for any trade can be divided into two parts — a profit target and a stop loss. Let’s start with the more pleasant of the two — profits. Given that short puts are a limited-reward trade, the decision of when to take profits is actually much easier than with trades that possess an unlimited reward.
The first potential profit target is to ride the position to expiration in an attempt to capture the maximum reward. This occurs if the put option remains out-of-the-money and expires worthless. So, let’s say we sold an August 45 strike put for $1 on a $50 stock. We could ride the short put to August expiration and, provided the stock remains above $45, the put will expire worthless allowing us to pocket the entire $100 ($1 x 100) of profit potential.
A second potential profit target is to buy back the put when it’s worth around 10 cents or less to capture the majority of the profit. Traders can often exit weeks before expiration with the bulk of their profits. Remaining in the position for an extra few weeks to capture the last 10 cents simply isn’t worth the risk. I’m an advocate of the early exit and typically bail on ALL my short option plays once I’ve captured 80%-90% of the max profit potential.
When selling out-of-the-money puts it’s not uncommon to win upwards of 80%-plus of the time. Your overall profitability, however, depends on how well you do at minimizing your loss on the 20% that go against you. Because the theoretical risk is substantial, it’s crucial to have a game plan to keep your losses minimal. Consider the following two techniques.
First, you could close the short put when the stock breaks a key support level and reverses into a downtrend. Typically, we sell puts on bullish or neutral stocks. That’s to say we expect them to NOT drop significantly. The breach of support, then, acts as a signal that your original premise was wrong and is thus an appropriate exit point.
A second exit idea is to close the short put if the stock reaches the strike price. In the example above where we sold the 45 strike put on a $50 stock, we would plan on closing the position if the stock dropped to $45. This prevents the put from moving in-the-money, which can cause your loss to really start accelerating.