25 June 2009

Naked Puts - Myths and Truths

Naked puts, no strategy is subject to more warnings from ersatz options experts and umm.... educators. Even some very good options people regurgitate some thoroughly dubious statements regarding naked puts. These generally encompass some sort of exhortation to not trade naked puts couched in such beauties as:

  1. Naked puts are extremely risky.
  2. Naked puts have unlimited risk.
  3. Don't ever trade naked puts.
  4. Naked puts cause diabetes and heart disease.

OK, I might have exaggerated a bit on the last point, but that is the general tone. All are nonsense without some qualifying conditions. Before I go on, I will point out that naked puts can be very risky if they are traded in a highly risky fashion, and we'll get into that in a moment.

Let's look at this with a bit of basic mathematics.

Naked Puts Are Extremely Risky

Believe it or not, naked puts are less risky than the underlying stock.

Let's take the example of Trader A buying 100 of XYZ common stock @ $50.00 (total outlay $5,000), and Trader B writing a contract of near month naked $50 puts and receiving $2.50 premium ($250 net premium received).

We are not looking at the upside on the stock here, although it should be recognised that the upside is capped at premium received for the option writer, we are looking specifically at risk alone.

At expiry, the put writer pockets the $250 premium no matter what happens to the stock. So if the stock closes @ $50 at option expiry, the option writer is $250 ahead of the stock owner whether assigned or not. Looks like the put writer is a winner in that instance.

What if the stock goes down though?

If the stock goes down, the put writer will likely be assigned and forced to pay $50 for stock that may be worth considerable less. Oh Yeah that's risky! But guess what, the stock buyer is holding stock, bought at $50, that is worth considerable less too. However the put writer has received $250 premium which he keeps, providing a cushion not available to the stock owner.

For example, if the stock is at $40 at option expiry, the stock owner will be down $1,000 at that point in time. Likewise, the put writer will have been assigned the stock @ $50, now worth $40; also a $1,000 loss. But the writer received that $250 premium which means the actual loss is $750.

What seems more risky to you $1,000 loss or $750 loss? The truth is that unless the stock is above $52.50 (in this example) the naked sold put will always be ahead of the stock.

There is another way of looking at this. Lots of folks trade naked puts all the time without ever giving it a second thought, they just trade them synthetically without ever realizing it. Enter the covered call. I have so many people argue with me that a covered call is not the same as a naked put, it's ridiculous. But the mathematics do not lie, a covered call IS a (synthetic) naked put.

Therefore it doesn't make a whole lot of sense to warn about naked puts when folks are completely at ease being long the stock, or long the stock and selling calls over it.

Most of the objections I encounter to this comparison do something like this = "Yeah but, my stop loss will take me out of the stock trade long before it gets to $40". Excuse me? Why is there this presumtion that because a person trades options, they do not have the brains to protect their capital? Options traders can use stop losses too, but it is more likely that they have another strategy in mind e.g. owning the shares or mitigation by adjustment or spreading off.

There are a couple of caveats to the above.

1/ All the above presumes an equal position size. In other words, if we're comparing naked puts to stock, it has to involve the same number, i.e. 100 stock compared to 1 standard option contract (or 1000 in some countries).

2/ Because of the possibilty of assignment, either at expiry or before, you need to have cash in your account to cover the purchase. Furthermore, you have to not mind winding up with the shares and/or have a plan on what to do once the shares are in your account.

There are some traders, through lack of caution or lack of knowledge, or perhaps just a bigger risk profile, who will write huge size out of the money puts, tens or perhaps hundred of contracts in order to collect premium with what they percieve as high probability. The problem is that a black swan event can (and eventually will) blow up those traders spectacularly.

It's proverbially snatching pennies in from in front of a steam roller. If the steam roller catches you, you get squashed. This may be what our option experts try to warn against, but it should be qualified with the actual maths.

Naked puts have unlimited risk

This is my favourite. The word "unlimited" means without limit, infinite. But do naked puts have unlimited risk?

What is the lowest a stock can go? It's zero isn't it? Can a stock go below zero? No, it can't. Therefore we know the maximum loss don't we?

Using the above example, our maximum loss on the naked put is $4,750, that is a $5,000 loss on the stock, less our $250 premium.

Is that unlimited? No!

Is risk unlimited? No! That's just silly.

A better term is "indeterminate risk".

Don't ever trade naked puts

OK don't, seriously! Not unless you are comfortable with the risk/reward profile. But don't not trade them because somebody regurgitated something he heard and never thought about. But if you trade covered calls, there is no reason why you shouldn't trade naked puts instead if you don't already own the stock.

And you shouldn't be afraid to trade them if you know, and are comfotable with the risks.


Mark Wolfinger said...

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 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'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.

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

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.

Best regards,

Wayne said...

Hi Mark,

You raise some excellent points I wished I'd covered in the blog.

In fact very worthy of discussing as an addendum in another blog post which I'll post up later

Thanks for the comments.


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