Credit/Credit Spread Strategy:
Naked Puts

AKA: Writing Puts, Cash-Secured Puts

ANALOGY/METAPHOR: Acquiring Stock for Substantial Discounts

ACTION: Sell 1 out of the money (OTM) put (or possibly at the money or even in the money) at a strike price you are able and willing to purchase 100 shares of the underlying stock for. In exchange, you receive a cash premium. As long as the closing price remains higher than the strike price, the premium you receive is complete profit, and you are free to write or sell another naked or cash-secured put following expriration. If the closing price ends below the strike price, you will be obligated to purchase the stock at the strike price. You can also buy back the put option prior to expiration, presumably (but not necessarily) for a loss.

DESCRIPTION: Many option traders will point out that naked puts and covered calls have a nearly identical risk profile. Indeed, they are both effective strategies for stocks that are flat or trending slightly higher, and they both offer about the same limited downside protection. However, the premium returns on a percentage basis may differ, especially if dividends are involved (the higher the dividend, the less the premium will be for an OTM call compared to an OTM put).

The analogy/metaphor above may seem less metaphoric and more literal than the description of some of the other strategies. For a long time, I viewed writing puts, or naked puts, as a version of being an insurance company. You essentially choose a strike price at which you're willing to purchase a stock if it moves down. It is, after all the other side of the long put trade.

You can apply the writing of naked puts this way, but there are some fundamental drawbacks to doing so. First, real insurance companies do not insure personal property without purchasing some form of reinsurance themselves in case of true, widespread catastrophe. That makes the bull put spread, bear call spread, and iron condor option trading strategies much closer to actual insurance operations.

The second, and more subtle, drawback is that writing naked puts as an insurance underwriting strategy leads to ambivalent trading. If you only write naked puts on stocks you really want to own, how do you define success? When the stock goes up and you keep the premium but miss out on ownership? Or when the stock takes a dive and you're there to catch it?

Most likely, you'll end up selecting stocks not because you want to own them (or wouldn't mind owning them) but because you don't think their share price will drop below the strike price between now and expiration. That's a great way to assemble a pretty lousy portfolio of formerly hot stocks you may or may not believe in or understand.

If, however, you view writing naked puts, or cash-secured puts primarily as a mechanism to acquire shares in companies you really want to own at subtantial discounts, not only will your selection improve, but arguably so will your returns. Really consider the profound implications of this trade. For each contract you write, you're getting paid to make an offer to buy 100 shares at a price lower than what the stock is currently selling for.

EXAMPLE: The entire stock market seems to be in a funk. The economy's in the doldrums and pessimism is currently reigning on Wall Street. Even The XYZ Zipper Company is feeling the pinch as consumers tighten their belts, so to speak, and seem to be wearing their pants longer (as in duration). As a result, the stock is trading all the way down at $21.50/share.

Sure, the short-term outlook isn't exactly rosy, but you're a believer in The XYZ Zipper Company's long-term prospects. You like the stock at the current price, but, savvy investor that you are, you decide to sell naked puts on the stock and see if you can't get the shares even cheaper. And if you can't? No big deal - you'll be content with a generous return in the form of collected premium for your time and trouble.

Because overall stock market volatility has increased, you're pleased to discover that two months out, put options at the $20 strike price are trading for $1 even. You quickly write the option and add a quick $100 to your brokerage account.

If the stock stays above $20 for the next two months, you're under no obligation to do anything other than enjoy your $100 as the put option expires worthless. In this example, that equates to a 5% return in two months ($100 divided by the $2000 you would be obligated to fork over should the put option be exercised), or a 30% annualized rate.

That's a reasonable consolation to keep in mind if the stock rebounds strongly and you miss out on a big move upward. Like covered calls, frequently the greatest risk with naked puts is that of missed opportunity.

If the stock continues lower and closes at expiration below $20/share, you will be obligated to purchase it for $20/share. But the $100 premium you receive effectively lowers your cost basis to $19/share. Yes, the stock could always tank in a big way, but purchasing a stock for $19/share that you were originally prepared to buy for $21.50 gives your portfolio an extra advantage that regular stock owners never get.

VARIATIONS: As with covered calls, you can monkey around with the strike prices. If you're feeling particularly bullish, or if you believe the stock will probably rebound, you can always write naked puts in the money (ITM).

For example, say the stock is trading @ $25/share and you decide to sell the $30 put options six months out for $7.50/contract. $5 of the $7.50 is intrinsic value, the fact that you're obligating to buy something for $5/share more than it's currently selling for. Granted, you could probably earn more than $2.50/contract in time value premium by writing the naked puts closer to or at the money (ATM), but if the stock does move up during those six months, you enable yourself to participate in up to $5/share capital appreciation in addition to the extrinsic premium.

NOTE: Writing in the money money puts is definitely more aggressive--and higher risk--than writing them out of the money.

OTHER: What's the difference between a naked put and a cash-secured put?

A cash-secured put is fairly self-evident. If you write put options against a stock and you hold enough cash (or T-bills in some cases) to purchase the stock outright should the option be assigned, you have written a cash-secured put.

The better question is, what exactly makes a naked put "naked"? And there are a couple of different answers.

The more official definition of a naked put is any short put position that isn't covered by a corresponding short stock position, or, for that matter, protected to an extent by a long put position at a lower strike price (which would form a bull put spread).

A lot of option traders use the term generically to refer to any short put position (which, for the sake of simplicity, is pretty much what I've done throughout this description). I think a better and more practical distinction to make between naked puts and cash secured puts, however, is to consider short puts to be naked whenever you lack the cash to purchase all your short put positions outright should they all be assigned to at once.

Not to lecture, but anytime you write puts, you should have enough cash on hand to pay for the underlying stock at the strike price. It's OK to go over some since your margin account would cover assignment in a worse case scenario. But it's both easy and tempting to overleverage yourself so that if a number of positions begin moving against you, you'll get the dreaded margin call and either have to fork over more money very quickly or end up taking stupid losses just to free up enough funds to satisfy your broker.

I've done it myself, and it's not enjoyable or good for your self-esteem.