26 June 2009

Naked Puts - An Addendum

Firstly something a little off topic. It has come to my attention that some media sites have been linking my content onto their sites without my knowledge. I don't mind, it's a bit flattering to be honest, but they haven't extended me the courtesy of attributing the content with a link to this blog such as every blogger does when quoting content. I have no desire to start threatening legal action, so I'll just be putting an embedded link at the top of my posts from now on.

Original Content Sigma Options


Yesterday I posted up some views on "Naked Puts - Myths And Truths", to which Mark Wolfinger from the excellent Options For Rookies blog, replied in the comments with some very good points I wanted to cover in a new post:

It's not 'being comfortable with the risks' that is the prime consideration.

What is important is for the trader to understand that there is an alternative strategy. Then the alternatives can be compared, and an intelligent choice can be made.

I strongly agree with Mark here. I find it a tad irksome the preponderance of options courses (that charge a rather enormous fee usually) that promote a single strategy as the key to options riches, be it covered calls (the usual) to put spreads, condors whatever. All are really great strategies for a particular market and/or volatility conditions. But no strategy is a catch all, to be applied without considering that there may be a better strategy for the moment.

I prefer selling put spreads. For me, the reduction in potential loss is well worth the reduced profit potential. That's my comfort zone, and each trader should find his/her own.

I have the same feeling in most cases, particularly with individual stocks. As I trade commodity options as well, for me it is not always so. But on stocks I just want to collect premium on, I don't want to be naked at all and also prefer a put spread.

I've moved into the camp that believes that naked put selling is ONLY for investors who want to buy shares as an investment. Traders would do better to use positions that are less risky. That's my opinion - it's not a demand that others agree.

Yes, as I mentioned in the previous post, you have to be prepared to end up with the stock if you trade naked puts. Unless you are happy to be holding the shares for some longer term objective, there are safer alternatives, as mentioned.

My only caveat comes with commodity options. Depending on the situation, based on seasonals, statistical studies, favourable IV etc., I'm quite happy to write naked for a straight out trade. Stuart Johnston covers this very well in his book Trading Options To Win. A great read if folks are into commodity options.

That in no way takes away the validity of Mark's comments however.

The fact that selling puts is less risky than buying stocks, doesn't mean it's a strategy without substantial risk.

Very true. However, if naked puts are risky, it then has to be accepted that long stock of equivalent position size is even more risky. The risk in both can be mitigated, save for humungous gaps.

Also as we know, there are legions of traders who do nothing but trade covered calls with no intention of holding stock long term, yet regard naked puts as the spawn of Satan. My objective was to skewer that misapprehension, arming folks with the knowledge to make more rational decisions. We know the covered call is synthetically equivalent to the naked put and once novice traders get their head around that, it presents them with one of two realisations

  1. Folks happy with the risk of covered calls may feel equally happy to trade naked puts of the same face value.
  2. Folks realise that covered calls are far more risky than the muppet that sold them a course has told them. I've even seen it claimed that covered calls carry zero risk. :-P

I hope I was careful enough to stress that one can increase their risk of ruin substantially with naked puts by trading too many contracts.

One more point. I don't dislike the idea of naked put selling. In fact, it's one of three strategies that I believe is suitable for rookies. But once the investor has some hands-on trading experience, I suggest moving on to the safer put spread.

I think that's good advice. The caveat being that people can still crash and burn with put spreads. There were a whole host of them I know of in Australia, the followers of one particular "guru" who promoted put spreads as a investing panacea, encouraging people to essentially have their entire capital as risk in correlated underlying stocks. The recent market crash machine gunned those poor folks to pieces.

Option people tend not to talk about money management very much (even specifically disregarded by some "gurus"), and this is paramount with any strategy, no matter how safe it is perceived to be. I think we option people make the mistake thinking that folks have some sort of position sizing algorithm in place. Often they don't and ruin may only be a market swing away with the majority of strategies if the leverage is cranked up enough.

My main point remains, don't be frightened of naked puts, they have their place in the option armoury.

There's plenty there for novices to think about, two slightly differing perspectives but not really that far away from each other.

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