Naked Puts: High-Risk, But A Win-Win Strategy

Includes: FSLR, HPQ
by: John Naccarelli

For those that use options to leverage, hedge or simply to generate additional income, I would like to reacquaint you to Naked or Uncovered Puts, an option strategy that is classified as high-risk by the broker-dealers. Naked puts involve selling the puts without being short the underlying security. As the seller or writer of the option, you have taken on an obligation to purchase the underlying security at the contract strike price during the option term (prior to expiration). With this strategy, the maximum potential gain is the premium received upon sale of the Put, while the maximum loss is the strike price minus the premium.

With that risk-reward scenario, one should ask why anyone would want to do this. Well, I have been using this strategy for years in situations when I want to purchase a stock, but do not want to do so at the current price and/or at current market levels. In this situation, one should also have a great deal of confidence in the future success of the enterprise and not anticipate a major price correction due to non-systematic risk. You should view a price correction in the stock, fundamentally and/or technically driven, as a great buying opportunity.

As a recommendation and an example of this strategy, I have been interested in going long on Hewlett-Packard (NYSE:HPQ), since the price correction in August. However, even with the recent correction down to the low 16s and a 3% yield, I was not ready to go long HPQ because I believed that the stock could trade down to 15 while the uncertainty and analyst debate continues. I do not see major downside risk in HPQ below $10.00 without a major market correction due to systematic or systemic risk - and examples of these risks are talked about every day by the media: war with Iran, the fiscal cliff, the ballooning deficit, weak housing recovery, unemployment, deep recession in Europe, etc.

Whether you agree or disagree with my assessment of HPQ, and there are plenty of arguments for and against my scenario, for purposes of this discussion, you will just have to agree with my position to follow the logic. If you agree, then you should take advantage of a naked put on HPQ.

For the past month or so, I have twice already sold short the 16 Puts January '13 and the 15 Puts March '13 when the stock has broken below $16.50 and covered these Puts when the stock broke above $18.25. If you are interested in a naked Put on HPQ, you may want to wait for the outcome of the upcoming HPQ Annual Analyst Day on October 3, 2012. Since this event could significantly move the stock, I have noticed that IV has increased as a result. You can also take advantage of this increased IV and higher Put price in advance of the event.

I may have the opportunity to again cover the short Puts with some positive news on Analyst Day or possibly add to my position with the converse. Currently, I am only short the March '13 Puts and may therefore be required to purchase HPQ at 15 with a sustained correction below 15. If that occurs, my acquisition cost would be approximately $13.55, because I received $1.45 upon selling short these Puts ($15 Strike - $1.45 Premium received = $13.45 acquisition cost). If the aforementioned were to occur, I will have accomplished my goal and should be pleased with an HPQ cost basis of $13.50 per share.

Take note however that there is a possibility that I may never acquire HPQ using this strategy, but I can also live with that situation while I continue to generate returns with the trade(s). During the past month or so, I have also used naked puts with First Solar (NASDAQ:FSLR) with the January 2013 Puts and a strike below $20 when the stock has traded in the $20-$21 price range. I am already long FSLR, so the circumstances and analysis are somewhat different with HPQ.

I will be very alert for the next week with such a volatile market environment, the skittish month of October behavior and the imminent earnings releases.

Disclosure: I am long FSLR. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.

Additional disclosure: I also have uncovered Puts on HPQ and FSLR.