Everyone has heard that writing naked or uncovered options is extremely high risk. This is not necessarily true.
The uncovered call is very risky because a stock's value can rise indefinitely, at least in theory. But when it comes to the naked put, it's a different story. The way to quantify the risk is to realize that a stock's price can only fall so far. Consequently, the market risk involved with naked puts is far less than those of naked calls. You also have to maintain the required margin your brokerage firm needs. This is normally one-half of the strike value. For example, if the strike is 20, exercise costs $2,000 so margin is $1,000.
The actual risk of the naked put is not even the difference between current value and zero. The formula is a bit more involved. The risk of the naked put is equal to:
The current value of the stock
Minus: The premium you received when selling the put
Minus: Tangible book value per share
While stock can trade below tangible book value, it is rare and unlikely. So if you want to generate a lot of "rules" to keep in mind:
1. You consider the net cost (strike minus premium) to be an exceptionally good price for the stock.
2. You are willing to have 100 shares put to you at the strike, meaning you are confident that even with market value below that strike, you think it will come back.
3. To avoid exercise, you are able to monitor developments and execute a forward-and-down roll. In other words, take the expiration out another month and, when possible, lower the strike at the same time.
4. The dividend on the underlying stock is attractive. If you do get exercised, it would be much more tolerable if you were also earning a 4% or 5% dividend.
5. You are planning to enter into a "recovery strategy" after exercise. Remembering that exercise is going to mean you pay more for the stock than its current market value, you need to wait out the price. As an alternative, you may want to write covered calls to improve your basis. Just be sure that if the covered call is exercised you come out profitably on the other end. The strike of the short call should offset your net paper loss on the exercise of the naked put.
6. On a pure cost level, risks are lower for lower-priced stocks. The worst-case risk is a large drop in market value of the stock. So a $20 stock is less risky than a $40 stock for naked call writing.
For anyone who has spent time studying options and speculating in the basic strategies, it becomes apparent that the range of potential uses of options is quite broad. So is the risk level, all the way from high-risk to ultra-conservative. This is what makes options so attractive. As you consider a range of possible strategies, whether for swing trading, pure speculation, or as part of a broader portfolio management plan, take another look at the naked put. Even naked, it might not look as bad as you think.
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