by Bryan Perry | March 27, 2014 10:21 am
There are three ways to make a bullish trade on a stock. You can simply buy the shares. You can also buy call options on the underlying stock. Or you can sell (short) a naked put, which can add some great leverage to your portfolio and take advantage of volatile periods like we’re in now. When you buy to open a put, you’re making a bet that a stock will go down, but when you sell to open a put, you’re taking the opposite stance and making a bet that a stock will rise.
Many traders shy away from naked puts because they don’t want to trade on margin or they don’t realize you can also carry out cash-secured naked puts. Using a trade I currently have open in my Cash Machine Trader service, let me walk you through both scenarios to show you the two ways you could open a naked put trade, how much money you would need and exactly how you profit.
My recommendation is to “sell to open” the Activision Blizzard (ATVI) Apr. $22 puts at $1.35 or more per contract, good till canceled. The option symbol is ATVI140419P00022000. I’d like to note that there are also weekly puts available at that strike price, so be sure to sell to open the regular monthly puts that expire on Apr. 19.
Game publisher Activision (ATVI) enjoyed very strong Q4 results while issuing solidly higher forward guidance with the release of what are forecast to be blockbuster games for Xbox and PlayStation platforms. This, coupled with mobile subscription growth that only stands to mushroom with the adoption of smartphone gaming, makes ATVI an ideal naked put candidate for a short-term trade.
The stock broke out of a six-month base on the earnings report and traded to $21.50 before coming in with the rest of the market to its current price of around $20.50. I recommend selling to open the Activision (ATVI) Apr. $22 puts here for what should be a money-good trade. By selling to open the puts, you would collect at least $1.35 ($135) for each contract you sell. That gets deposited to your brokerage account immediately, so you essentially get paid up front.
You could easily execute the ATVI naked put trade on a cash-secured basis. Your broker would simply require that you have enough un-allocated capital to buy 100 shares of ATVI at the $22 strike price for every 1 naked put contract you sell.
So, if you sold to open one naked put contract, you could potentially need $2,200 to buy 100 shares of ATVI at the $22 strike price. This is called “getting put the shares.” A trader who sold to open the ATVI Apr. $22 puts would likely get put the shares if ATVI is trading below $22 at April expiration.
Why is that?
Because when you sold to open the put, you sold the right for another trader to make you buy ATVI shares at $22 regardless of where ATVI was trading at April expirations. If someone is holding the right to make you buy shares of ATVI at $22 even if ATVI is trading at $20, they’re going to exercise that right and unload their shares that are only valued at $20 onto you for $22.
But, remember, owing shares of ATVI is not necessarily a bad thing as the charts are telling me that ATVI is in a near-term bullish trend.
The more important point is that if you are selling cash-secured naked puts, only sell as many contracts that correspond to how many shares you’re comfortable owning of a stock as 1 contract equals 100 shares you would need to purchase, 2 contracts equals 200 shares you would need to purchase, 3 contracts equals 300 shares you would need to purchase and so on.
There’s a lot of misunderstanding about how margin works, but one of the biggest misconceptions is that you need a ton of money to trade on margin. As long as you have an open account with your broker, for most brokers you really only need an additional $5,000 to establish a margin account. Of course, each broker is slightly different but $5,000 is a typical requirement.
By depositing an additional $5,000 into your brokerage account, you can be eligible to use margin and carry out naked puts on margin. This is known as regular or “Reg T” margin. And, generally speaking, that $5,000 will give you enough trading power to execute the two or three naked puts we have open at any given time.
On the following page, I’ll show you exactly how you can calculate your margin costs for a naked put.
Margin requirements for a naked put I recommend in Cash Machine Trader are generally around $500 to $1,500 per trade, assuming you trade 1 to 3 contracts. Ergo, out of that $5,000 margin fund, you could easily have two or three naked puts going simultaneously – more if you trade fewer contracts. I typically only have up to three naked puts open at a time, as our main strategy in Cash Machine Trader is short-term covered calls which can be executed in just about any account, even IRAs.
But I like the immediate gratification of naked puts and that they take advantage of the fact that the vast majority of options expire worthless – some estimates say as much as 90%.
Your broker will be able to tell you exactly how much of your margin money will be allocated to a naked put trade. But for a very simple view, the Chicago Board Options Exchange, or CBOE, has a great margin calculator that lets you easily estimate how much margin a typical broker will require for specific trading strategies. Find that margin calculator here and, when you do, select “short put” as your strategy and plug in the details of the ATVI trade.
When doing so, using an illustrative position size of 1 contract, the calculator tells me I could expect a broker to require $556.80 in margin, I would collect $135 from the proceeds of selling one naked put.
The CBOE margin calculator also gives you a “margin call” amount, but that’s not exactly relevant for our purposes, as there are three potential outcomes of naked put trade:
1. The intended outcome, which is that ATVI is trading above the $22 strike price at April expiration and the put we sold to open expires worthless allowing us to keep 100% of the money we collected upfront. Note, it’s not that we doubled our money, but that we collected $1.35 ($135) per put contract that we sold to open and at options expiration, we kept 100% of that.
2. At some point before expiration, ATVI’s chart signals a change in trend and I want to exit the trade early. This can result in a partial profit, or a loss, depending on the situation.
If we sold the naked puts at $1.35, and they have fallen in value to, say, $1.00, we could “buy back to close” the puts and keep $0.35 of the money we originally collected. This means we’d have a net gain in the trade.
But if we sold the naked puts at $1.35, and they have risen in value to, say, $1.50, we would still “buy back to close” the puts but we’d have to pay $1.50 to buy them back. This means we’d have a net loss in the trade.
3. At options expiration, ATVI shares are trading below $22, and the person who bought our naked put contract exercises his or her right to make us buy shares of ATVI at the $22 strike price.
As noted above, owing shares of ATVI is not necessarily a bad thing as the charts are still telling me that ATVI is in a near-term bullish trend. We would just take ownership of the shares at a cost basis of the $22 purchase price, minus any of the money we collected upfront. In this case, we got $1.35, so our cost basis for ATVI shares is $20.65. You simply need to wait until ATVI moves above that $20.65 cost basis and sell your shares at a profit. It’s as easy as that.
So, the “worst case” scenarios for naked puts aren’t so bad, as long as you keep your positions small. Naked put trades are one of the few options endeavors where “worthless is worthwhile” and I hope I’ve empowered you today to take advantage of their potential.
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