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"Let's Get Naked" Part 1

 “Let’s Get Naked”

“An investment in knowledge always pays the best interest.”

                                                                                                                                                                -Benjamin Franklin

 

I know, I know,….based on the title you were expecting something a little more exciting when you clicked over, or perhaps you thought it was Golf Digest’s latest article on Tiger Woods.  Either way, you are probably disappointed, but don’t get too discouraged, because this “Trade School” is exotic in its own right.  Today’s “Trade School” is part 1 of a 2 part series on Selling Naked Options.  Now, there are many different ways to sell options, however we believe that Selling out-of-the-money Put Options or Naked Options is one of the more profitable and consistent strategies you can implement into your war chest.  This is a strategy that professional traders have used for years and they don’t want you to know about it. Why?  Because, like us, they know by being a seller of options, rather than a buyer, the odds of winning are overwhelmingly in your favor.

So, in this week’s trade school we are going to describe the 6 different reasons why selling put options can improve your chances of success in your overall portfolio, as well as educate you on the risk and downfalls of the “naked” option strategy.  Next, we will introduce you to the most effective way to acquire ownership in a stock using the naked put strategy and do a step by step real life example on how to execute this trade.  The world of options is like anything else; the more you know, the more doors that are opened for you.  So, after a few weeks have passed and you have a solid understanding of this strategy, I will unleash part 2 of the “Let’s Get Naked” series and show you how we establish a simple and efficient game plan for selling puts on stocks that we have NO intention of owning, but for the sole purpose of generating a steady stream of income month after month.  If any of this makes you blush, then it’s time “To Get Naked.”

Before we dive into the details of selling options, let’s review the basics.  To sell an option “Naked” or “Uncovered” means you do not own the underlying security.  With Covered Calls we own the stock, so we are covered when we sell a call against it.   With Naked Puts we are selling against the security individually, or not in conjunction with anything else, therefore we are “Naked”.  Most of you are probably more familiar with buying options.  You think the market is going up so you “Buy a Call,” you think the markets going down, you “Buy a Put.”  It cost you a fixed amount of money to buy this call and/or put and if the market goes in the direction you think it should, that option goes up in value and you profit.  If it goes against you, the worst that can happen is you lose all of your initial investment, which is usually only a fraction of the price of the stock.  Selling an option is just the opposite, if we are bullish we are going to sell a put and if we are bearish we can sell a call.  Now we don’t recommend selling naked calls on stocks (unless you use a “spread”; see future “Trade Schools”), but a much more effective strategy for going long a stock is to sell a put out-of-the-money and get paid while you wait for that stock to reach your desired price or go up in value.  Like I mentioned in the first paragraph, this puts the odds of winning in your favor.  So, let’s move away from the basics and look at other reasons why this strategy is so advantageous. 

Why Sell Options

There are 6 good reasons why we believe selling options should be a part of your arsenal:

Reason #1:  The odds are in your favor!

For every buyer there is a seller, it’s the Law of the Market.  So, if most people that buy options as their investment vehicle of choice lose money, then that means that most traders that sell options make money.  Actually, it’s even more convincing than that; The Chicago Mercantile Exchange estimates that almost 75% of all options expire worthless at expiration, (the ultimate goal of an option seller.)  Many industry experts argue that the average is as low as 65% or as high as 82%.  I however, choose not to split hairs, and recognize that no matter how you look at it, as soon as you sell an option, the odds are in your favor.  If those statistics aren’t good enough for you, sell options that favor the trend of the underline security and your chances of success will increase dramatically. 

Reason #2:  You can’t stop time!

Since options are a wasting asset (think 2010 BMW you want to buy) that means the more time that passes, the more money you make.  Time is always working for you the seller and always working against the buyer of the option.  This fact is accelerated in the last 30 days of options life, so we typically only sell options with 30-45 days left until expiration.  Again increasing our odds of success even more!

Reason #3: Trade Management is simple!

One of the hardest things about trading is knowing when to cut your losses short, and let your profits run.  The reason being, is that most trading strategies require you to take a large amount of small losers, while waiting for the one or two big winners to recoup all your losses or to become profitable.  When you sell an option you know the maximum amount of profit you can make on a trade from the beginning, whether the market goes up, down, or sideways, as long as the stock is above your strike price, you will reach maximum profit.  No decisions required, a.k.a., 8 hours of sleep.

Reason #4:  You don’t have to be exact!

When you buy an option on a stock, that stock must go in a certain direction in a certain period of time.  When it doesn’t, you start to lose money…fast.  Option selling allows you to look where the market will not go, instead of where you “think” it should go.  The following is a great example of making a case for selling vs. buying options.  It is from James Cordier’s paper titled “Confessions of a Professional Option Seller”:

Imagine yourself as the sole outfielder in a Major League Baseball game. As a traditional outfielder, your job would be to try to predict where the batter will hit the ball, and then stand in that spot. That is what Option BUYERS do. But in this game, all you have to do is look across the entire outfield, and pick the spot where you think that hitter is LEAST likely to hit the ball. Then go stand there. When that hitter gets

up to bat, he can hit it anywhere in that ball bark. As long as it doesn’t come right to you, he is out and you win. Is that a game you would like to play? If it is, you might like option selling.

 

Reason #5: The trend is REALLY your friend!

 

Trend following isn’t as easy as the commercials make it sound.  If it were, we would be out of a job and everyone would make money in the markets.  However, with selling options you do not have to time the next move up in a stock perfectly, you can simply sell a put 10% or more beneath the current price of the stock allowing you to take part in an uptrend even if your hunch or analysis is initially wrong.

 

Reason #6:  Risk is manageable!

 

Selling options is tagged with the unlimited risk title whenever it is brought up by stock brokers or financial advisors.  However, risk in selling options is just as definable and controllable as any other trading strategy in the equities or futures markets.  It requires trade management and overall knowledge of the fundamentals on the security you are writing puts against.  However, if you write a put out-of-the-money, favoring the trend, in a short time period, then you are putting yourself in control right off the bat, and that is the most effective risk management of all.

 

 

The 3 Downfalls of Selling Put Options

 

You can probably guess by now that I enjoy selling options, however, it is important that you understand the risk that comes along with selling options.  In my opinion, the benefits outweigh the risks, but let’s go over what can go wrong and I will let you decide for yourself. 

 

1.        Limited Profit Potential: When you sell a put, your profit potential is limited to the premium you collect, no matter how far the stock moves away from your strike price; your potential profit will always remain the same.  So, this is not the strategy for trying to make 50% a year, this is for the investor who likes to hit singles every month, instead of homeruns every once in awhile.

 

2.       Unlimited Risk:  I described my views on risk in “Reason #6,” however if you want to sell naked puts you need to understand there is always a risk of losing money equivalent to the stock you sold a put on by it going to “0.”  However, this is also the risk if you own a stock outright, RIGHT?  Bottom line, if you’re uncomfortable with this, use a strategy with known risk parameters, such as spreads, but if you follow the rules you will be able to control your risk like any other trading strategy.

 

3.       “Professional” Money Managers Won’t Agree with You:  “We fear most, that of which we do not understand.”  Many brokers, advisors, and investment professionals do not understand the option selling strategy, so they will tell you that it is not a good idea, or your account is not approved for it.  The good news is you have two options, you can educate them on their lack of understanding, or you can switch brokers, because there are plenty of brokers that know this is a great tool for their clients to use.

 

So, there is a quick overview on selling options, along with the pros and cons of the naked put strategy.  Like I mentioned above, there are two different purposes for the naked put strategy, for Part 1 of the series our purpose is to acquire a stock at a discount with the intention of holding that stock for the medium to long term.  This is how that works.

 

Part 1: Buying a stock at a discount

 

The simplest and most straightforward strategy for selling a put is for the purpose of buying a stock at a discount.  We’ve all been in the situation where there is a stock that you like, but not at the current price.  It is currently too high for you to feel comfortable buying, but you could see some value in the stock if it pulled back a few dollars.  For this situation, selling a put is your best option (no pun intended). 

 

By selling a put on this stock you assume the obligation to buy the underlying security.  Meaning if the stock drops to, or below the strike price that you wrote the put at, you will be required to buy it at that strike price, all while collecting a premium.

 

Now before you go crazy acquiring stocks by using naked puts, there are 6 questions you should ask yourself before you sell a put on any stock.

 

1.       Is this a stock I want to own in my portfolio?

2.       Do I have the cash or margin available in my account to buy this stock if my strike price is hit?

3.       Am I willing to own this stock if it drops significantly below my strike price?

 

If you can answer yes to these three questions, then it’s time to dig a little deeper.

 

4.       What’s the upside potential of owning this stock?

5.       What strike price should I sell the put at?

6.       What kind of premium can I receive for selling the put 45 days or less out, and is that premium worth my while?

 

Let’s do a real life example:

 

Cash Available for Trade $15,000

 

Exxon Mobile (XOM) is one of our favorite stocks to write puts against in any given month because of its volatility and the consistent trading range it has been in for over a year. Not only is it a good stock to write puts on to generate monthly income, it is also good stock to own for your stock portfolio.  XOM has currently retraced 14% and is trading at 65.54 at the time of this “Trade School.”  It is almost to its technical support level of 65.   If it does go through 65, it has more support at 62 and it hasn’t been lower than that for over 4 years.  It’s currently in a trading range and has upside potential of 8-15% if it decides to test its technical resistance levels at 70 and 75.  Finally, because XOM is part of our core portfolio stocks I know that since 1990 XOM, on average, goes up twice as much in March and April than it does any of the other 10 months of the year.  So, if I were to acquire XOM through a naked put on February 19th, the day options expire, I would feel pretty good about my chances of making money over the next 2 months.  

 

The next step is to determine my strike price to sell the put at and see if the premium I am receiving meets my standards.  I like the XOM February 65 puts because of the strong technical support and the current premium of $1.53.  Now this is only $0.54 away from my strike, but remember I think there is a lot of potential in owning XOM at 65 and I want to own it if it goes there; if it doesn’t I will collect my premium and possibly do it again next month, no harm done.  $1.53 is a great premium for only 22 days left to February expiration; in fact it is equivalent to owning XOM and immediately receiving a 2.3% return ($1.53/$65.54).  Anything over a 1% return per 30 days is a worthwhile premium. 

I answered my 6 questions and I feel good about this trade.  Let’s execute it.

 

Item

Stats

Comments

Company

XOM

Exxon Mobile

Stock Price

65.54

 

Put Strike

65

The next support level

Days to Expiration

22 Days

Always do options w/ ≤ 45 days

Premium

$1.53

2.3% return

Contracts

2

1 per 100 shares

Cost if stock is put to us

$13,000

Strike Price x Contracts x 100

Downside Breakeven

$63.47

Strike Price – Premium

Stock Acquired At:

Any price below 65

You always keep the premium

Maximum Gain Stays Above 65

$306

Premium x 2 x 100

Maximum Gain Drops Below 65

$306 + Increase in XOM

Premium + Stock Price Increase

Maximum Loss Stays Above 65

None

 

Maximum Loss Drops Below 65

$306 – Decrease in XOM

 

 

 

Once your trade is entered you watch and wait.  If XOM goes up tomorrow and never reaches our strike price of 65, that’s ok, we keep our $306 premium and look to sell puts on XOM in March or another top notch stock worthy of our portfolio.  If XOM continues down past our strike of 65 it will get put to us and we will immediately be long 200 shares of XOM and that’s when our research and analysis on XOM proves itself.  My bet is, if it goes through 65 it won’t stay there for long and we will be rewarded handsomely through April.  But the most important thing is we win either way.  If you can feel confident in both scenario’s, then you know you’ve sold a put on the right stock. 

Part 1 is done.  You have just learned how to earn income on stock while you wait for it to reach a price you feel comfortable buying it at.  This is the only way I buy stocks and I recommend you use this option strategy at the bare minimum in your portfolio management.  The best thing about options is there something for everyone, no matter what your risk pallet is.  So if this doesn’t appeal to you, learn it anyway, this way you know how the guy taking your money is thinking.  If this does appeal to you, then look out, because part 2 will completely revolutionize how you view stocks.

 

 

 



Disclosure: no positions in the stocks mentioned