The following is a post by Christopher Ebert, who uses his engineering background to mix and match options as a means of preserving portfolio wealth while outpacing inflation. He studies options daily, trade options almost exclusively, and enjoys sharing his experiences with anyone who is interested.

Are Naked Puts Risky Business? (Part 1)

Let’s assume an investor has $60,000 invested in an employer’s 401K plan, allocated almost entirely to mutual funds that use the S&P 500® as a benchmark. Heeding the advice of the administrators of the plan, he is willing to remain married to that investment, even if it were to lose 10% of its value over the next two weeks. He reassures himself that a 10% downturn would eventually be erased; while, in the meantime, he is buying more shares. But, no matter how he rationalizes it, he is only making excuses for sticking with a bad marriage.

Now, let’s consider an alternative. Let’s say he decides to explore the naked put lifestyle. He gets a trial separation from his $60,000 worth of mutual funds and transfers the proceeds safely into cash. Then he contacts a broker and sets up an account with margin and option privileges. Next, he sells naked puts on an ETF that tracks the S&P, such as the State Street Global Advisors SPDR® fund, SPY. With the recent volatility pushing up premiums, he might collect $2,000 on 5 contracts of at-the-money naked puts on SPY if he sold them two weeks before expiration. Risky? Yes; but no more risky than holding onto his failed marriage. What’s the worst that could happen? Obviously, a 10% downturn in the S&P would be unwelcome, but its effect on him, as a naked put seller, would merely be to get remarried when the contracts expired. He would be obligated to purchase shares of the same benchmark he was previously willing to hold ‘until death’ anyway. However, the temporary separation from his mutual fund has put an extra $2,000 in his pocket

So, what is keeping him from divorcing his investments and selling naked puts? Like many, his greatest fear is probably that once he is separated from his investments, they will find immediate favor with other investors, and he will miss out on all that price action. Let’s say he sells his mutual funds, and opts for the naked puts, only to watch the S&P soar 10%; he still pockets the premium from the options, which raises the value of his account from $60,000 to $62,000 in just two short weeks. That’s an amazing 86% annualized return!

Sure, he could wallow in self-pity about what might have been; a $6,000 return if he had remained married, but if he takes a minute to stop and think, he may realize exactly what he has accomplished. He has increased the value of his account by $2,000, without being married to his portfolio. If that doesn’t boost his self-esteem, nothing will. He is free; free to sell more naked puts, as many as he wants, as often as he likes. Of course, he is always taking on the risk that selling those naked puts will lead him into becoming re-married at some point; but in the meantime he can enjoy his freedom, and fantasize about all of the ways he could spend that extra cash in his pocket; funds that would likely not have been there if he had remained in his buy-and-hold relationship.

A naked put is definitely not for everyone. The risks involved scare most traditional investors into avoiding them, and for good reason. Meanwhile, its identical twin, the covered call, seems to get an unwarranted degree of attention, despite having the exact amount of risk. Furthermore, the traditional method of buy-and-hold exposes an investor to the same amount of risk as a naked put, yet this traditional way of investing seems to receive more popularity than naked puts and covered calls, combined. For many traders, a naked put just doesn’t make sense; but for those who can not let go of the buy-and-hold mindset, they would be doing themselves a favor by contacting their broker and asking “Are naked puts right for me?”

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3 Responses to “Are Naked Puts Risky Business? (Part 2)”

  1. Ron Says:

    Hello Chris,

    great info and advice on selling puts.

    can you give an example on using margin to sell puts.

    I use ameritrade as my broker and trying to figure out how the game plan would shake out.

    Thank You
    Ron

  2. Christopher Ebert Says:

    Ron,
    The requirements for margin differ from broker to broker, but many of them employ two similar formulas. The most common formula generally requires margin equal to 20% of the underlying value, reduced by the out-of-the-money amount.

    For example: On a stock trading at $100, selling 10 $85 naked puts would require margin of 20% of the value of those 1000 shares (20% of $100,000 = $20,000) reduced by the amount the puts are out-of-the-money, in this case $15 ($15 times 1000 shares =$15,000). So the initial margin requirement would be $5,000. The premium received is then added to the calculation, so if the premium was $1 per share ($1,000), the total requirement would be $6,000.

    An alternate formula is often used on out-of-the-money options. The most common formula is based on 10% of the exercise value. On 10 $85 puts, 10% of the exercise value is (10% of $85,000 = $8,500). Again, the premium received is added, so the total margin requirement would be $9,500.

    As might be expected, most brokers will choose the higher of the 20% and 10% calculations, so here it would be $9,500. But that is only the initial requirement. As the underlying price changes, the requirement will also change. If the option ends up in-the-money, the requirement will increase, but will not usually go higher than 20% of the strike price (plus the premium received).

    On the $85 puts, the greatest possible margin requirement in most circumstances would be (20% of $85,000 = $17,000) plus the $1,000 premium equals $18,000. When trading naked puts, its always a good idea to keep the maximum amount set aside in order to avoid margin calls.

    Even though setting aside $18,000 might seem like a lot, it is still much less than what would be required for a covered call. In a $50,000 account with $50,000 margin, an $85 covered call would require the purchase of $100,000 worth of underlying stock. While theoretically possible, the account would basically be dedicated to that covered call until it expired.

    It should be noted that the requirements can be significantly higher on leveraged ETFs. Brokers may use a 60%/30% calculation on a 3x ETF instead of the usual 20%/10%.

  3. Ron Says:

    Hello Chris

    appreciate the time you took to answer my question.

    learning from reading your posts.

    Thank You
    Ron

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