The strategy of selling naked puts — which means shorting, or “Selling to Open,” put options without also being short the underlying stock or owning a long put against the naked position — actually holds a bit less risk than just buying a stock.
Naked puts reduce the cost basis of the stock (on a short-term trade). In acceptance that there is a cap on the upside potential, we exchange it for a strategy that is more likely to end up profitable than the outright stock ownership.
I was talking about this strategy with a friend of mine, Bill Jones, who asked me if there is a way to increase the potential profit-versus-loss ratio.
Here are the highlights of our discussion:
Bill — “Chris, on one hand, I like having better odds of success because I know I can profit from naked puts if the stock trades up, sideways or even slightly lower.”
(This is true because since we’re essentially selling short the naked put option, we profit when the put option loses its value as a result of time passing.)
“But on the other hand, if the stock doubles in price, I will only make the amount that someone has paid me when I sell that put option, so the profit is limited. It seems like selling naked puts is actually risky when you consider the reward.”
Me — “First of all, the risk-versus-reward ratio makes sense when you consider the fact that odds of success increase. And it’s not a risky strategy, but maybe it’s just not exactly what you’re looking for.
“Consider the fact that I just heard, from a very reliable source, that the world’s largest options trader is a guy by the name of Warren Buffett. In case you’ve never heard of him, he’s been jumping in and out of first place on the Forbes 400 richest people list for decades.
“But, he certainly isn’t a speculator. He’s a value investor, and not a guy who I’d consider a ‘risky’ player.”
Bill — “I know the margin requirement for a put spread is only about 20% (1/5) of the underlying stock position, so I can sell five times as many put options, so at least I can profit a lot more that way if the stock trades flat or up. But that opens me up to five times the downside risk! What do you suggest?”
Me — “I suggest that you read the Tycoon Report on Tuesday and I’ll write an article about ‘vertical put spreads,’ since I can’t legally give you individualized investment advice.”
Bill — “No, seriously.”
Me — “No … seriously.”
So if you’re like Bill and ready to learn the basics about the possible profits that are waiting for you as a put seller, I’ll cover the basics and give you three possible options trading scenarios that you can add to your portfolio today!
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BACK TO BASICS
Here’s a quick review on selling naked puts. (Please note that the following example is used for illustrative purposes, using sample prices, and is not a recommendation.)
The Stock Trader’s Profit/Loss Scenario
If a stock trader buys 100 shares of the Oil HOLDRs Trust (OIH), an oil-service Exchange-Traded Fund, at $170:
- Requirement: $17,000 cash or $8,500 on margin
- Maximum upside potential: Infinite
- Downside risk: $17,000
- Breakeven price: $170
The Put Seller’s Profit/Loss Scenario
Consider the seller of one naked put option. (Note: If the seller is “assigned” by the option buyer, this means that the seller would be obligated to buy 100 shares of OIH at the strike price.)
Let’s stay with our example of the OIH trading at $170.
In this example, we will use the OIH March 170 Put option, which is trading at $7. By selling one naked put option contract, we are saying we are willing to buy 100 shares of OIH at $170 upon request before March options expiration. In exchange for the put option contract that we are selling, we get $700.
- Requirement: Strike price x 100 shares – premium received ($17,000 – $700 = $16,300) in a non-margin account. However this is typically done in a margin account with a 20% requirement. ($16,300 x 0.20 = $3,260 cash outlay)
- Maximum Upside Potential: There are two possibilities.
The upside if the person who purchased the March 170 Put does not exercise the put option (because OIH moved much higher, making it pointless to exercise) is the 7-point ($700) premium received for the put option that we sold.
The upside if the person who purchased the March 170 Put does exercise the put option is infinite (because, then they’d actually own 100 shares of OIH).
- Downside risk: Strike Price x 100 shares – premium received ($17,000 – $700 = $16,300)
- Breakeven point: $163.
NOTE: Be sure to check with your options trading broker about their specific margin requirements before trying this or any strategy for the first time.
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BACK TO BILL
Remember, Bill said that he could increase his reward tremendously, but he also brought up the excellent point that he would then be increasing his risk.
What he is saying is that, using our OIH example, the margin requirement is $3,260 with a $700 upside. And, he’s acknowledging that instead of buying 100 shares of OIH, which requires $17,000 (or $8,500 on margin), or selling the naked puts, which requires $3,260, he can take about $16,300 and sell five times as many put options, which will bring in $3,500 in premium ($700 x 5).
At the same time, he realizes even though his breakeven point is still $163, he would be losing $500 (instead of $100) for every point that the stock traded below $163.
His concern here is if the stock or ETF on which he sold naked puts trades down by a large amount (e.g., if it lost 50% in a day), he would lose five times more than he would have lost past his breakeven point. But, he likes the concept of the high-probability bet, so he’s tempted to use the high leverage.
MY ANSWER FOR HIM
I know you like the concept of profiting from time decay — i.e., the deterioration of the option price due to time passing — of the option that you sold. If your focus is to profit from a security by staying above your breakeven point with either little or no downside movement (as opposed to your focus being on trying to actually buying the stock), then you should try selling vertical put spreads.
GOING VERTICAL
With a vertical put spread, you are basically doing the same thing that you would do with a naked put, except you’re also buying insurance on the position by purchasing another put with a lower strike price. The margin requirement is the difference between the two strike prices.
So, let’s go back to our OIH example using March 170 Put options.
When we enter a spread, or a two-sided trade, we enter both “legs” of the trade at the same time (which is technically entering two trades simultaneously).
Here are three examples, because there are a few different ways to profit.
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EXAMPLE NO.1: SELLING A VERTICAL PUT SPREAD
Let’s look at selling a vertical put spread for $2. When you enter a spread, you only enter one price: the amount that you intend to pay or receive. However, to break down the mechanics behind the trade, I’ll explain it using two prices separately.
Just as we did in our example above, we would sell the March 170 Put for $7. (This is “leg 1,” where we collect a credit for the option sale.)
Then, we would buy the March 165 Put, which is trading at $5. (This is “leg 2,” where we pay a debit to “Buy to Open” this portion of the spread.)
Keep in mind, you don’t have to sell at the bid price and buy at the asking price — you can fish for a better price. (For example, you can enter a spread order to get in for a credit of $2, or the difference between the money we collect for the short leg and the money we pay for the long one.)
This is called a bull-put spread or a put credit spread. No matter what you call it, you are collecting more money than you spend to enter the trade.
Since we received $7 and spent $5, we have collected a total net credit of $2.
Here, our breakeven point is $168. With OIH trading anywhere above $168, you’re profitable.
Our maximum downside risk (as long as you close out the position before expiration day) is $300 per contract. So if we sold one March 170, and bought one March 165 against it in the same transaction, I’d consider that one contract.
If you do this, the risk is $300. So, why risk $300 to make $200? Because the odds of success increase tremendously when you profit from time passing, and your breakeven point is lower than the securities price.
If you are highly confident that the security will do what you think it should, I’d recommend structuring the spread with two options that have strike prices close to the price of the underlying security’s price. This may be because there is a good risk-versus-reward picture in the security itself due to it being near some vital support level, like if it corrected back to its uptrend line or is bouncing off of historically potent horizontal support.
Margin requirement: The potential loss. This is the difference between the strike prices minus the premium received. Because the risk here is $300, that’s your margin requirement.
Insurance of owning a put with the next lower strike price: When you think about it, what happens if OIH trades all the way down to $10? You sold the March 170 Put for $7, which obligates you to buy OIH at $170 ($10 higher than$160). If you simply sold that put naked (uncovered), your loss (if you only sold one put for $700) would be $153 (or, $160 – $7).
However, since this is a vertical spread, you also own the March 165 Put, meaning that someone else is obligated to buy OIH from you for $165 if you choose to exercise your right as an option buyer.
So, per both contracts (your short March 170 and your long March 165), you would technically have to buy OIH for $170, and then sell it for $165 — a $5 loss.
Since you received $2 for the vertical spread, you would only lose $3. (If your broker is half-decent, you wouldn’t have to put up the cash to actually buy OIH for $170 and sell it at $165. Be sure to ask.)
So, Bill, if you’re interested in leverage with less risk (and less reward) than a naked put, instead of selling one naked put on OIH with a requirement of $3,250, you can sell the vertical spread x 11 with a requirement of $3,300 ($300 margin requirement x 13). In this case, you take in a premium of $2,600 instead of the $700 that you’d get from a naked put spread.
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EXAMPLE NO. 2: SELLING A LOWER-STRIKE SPREAD
If you want a little more downside leeway (say, you think OIH may fluctuate to as low as $163.50), you might sell the March 165-160 put spread (instead of the March 170-165 spread).
In this case, you’re giving up some upside in order to decrease the downside risk of OIH because you have a lower breakeven point.
If you sell the March 165-160 put spread, you could receive $1.50. Again, the risk is the difference between the strike prices minus the premiums received (which is $5 – $1.50 = $3.50).
At first glance, this may not seem smart when you consider the risk is $3.50 to make $1.50. However, let’s say the odds of success have increased, and that OIH is trading at $170 and your breakeven point is now $163.50 (instead of $168 in the previous example).
Also, if you think about the risk of owning OIH, you’ll recall that if the stock moved down to $163.50, you would already be down $6.50 a share. However, with a vertical spread, you’re profitable if OIH is trading anywhere above $163.50.
EXAMPLE NO. 3: EXPANDING THE SPREAD
If you want to receive a larger premium, then you can sell the March 160-150 vertical put spread for $2. Notice that the difference in strike prices is now 10 points instead of five. This increases the dollar amount that you would risk, but it also increases the odds of success. The risk-versus-reward scenario is now 8-to-2.
If you sell just one March 160 Put and buy one March 150 Put against it, your maximum risk is $800 for each contract. This is because your risk is a 10-point strike price difference, minus the $2 received for selling the spread.
Your breakeven point is $158.
Your margin requirement is $800 per.
Read on for some tips to keep in mind before you start trading vertical put spreads. …
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3 TIPS TO GET YOU STARTED TRADING VERTICAL PUT SPREADS
1) When people such as brokers — who will benefit from you conducting these trades in larger quantity or trading more frequently — talk to you about this, they might only focus on the fact that, in our last example, you are only committing $800 to make $200 — a 25% gain in a month. That sounds quite appealing.
But make no mistake; you are risking $800 to make $200 as compared to owning OIH, where the risk of the required cash balance (margin) is less. Although the odds of success increase tremendously with a vertical put spread, we are using leverage. And don’t let anyone convince you otherwise.
2) Because of the leverage factor, I prefer to use options on an ETF or index for vertical put spreads. This is because individual stocks are much more likely to lose 50% in a day than an index or ETF, as indices and ETFs are diversified. In short, I prefer the diversified trading vehicle because it moves slower, and I have more time to realize when my position is going the wrong way.
3) You can unwind your spread at any time (whether or not it’s working in your favor). You don’t have to (and absolutely shouldn’t) let the spread expire even if it’s only worth 5 cents.
If it’s that cheap, then it’s even more of a reason to get out, as you can only profit by another 5 cents, but you could still lose your maximum risk. Try to always be out of options positions at least 10 calendar days before expiration.
Chris Rowe is the Chief Investment Officer for Tycoon Publishing’s The Trend Rider. To learn more about him, click here to read his bio.
