Naked Put Power

The covered call is a well-known, widely liked option strategy. But often overlooked is the equally attractive uncovered, or naked put. The naked put has the same market risk characteristics as the covered call, with some distinct advantages: You do not have to own 100 shares to write a naked put, and the put can be rolled forward to any strike you want without having to worry about exercise.

Some disadvantages have to be observed as well. You need to deposit collateral equal to 20% of the put’s strike price value, and you do not earn dividends with a naked put as you do with a covered call.

Overall, the naked put is desirable because of its flexibility. Not being tied to stock ownership, the major restriction is the collateral requirement. However, opening a naked put with a few important attributes provides the same level of income as a covered call.

Two primary features maximize the opportunity with naked puts. Ideally, the naked put should be purchased well out-of-the-money with a good buffer zone between the strike and the current price. This protects you against exercise if and when the underlying moves against you and the put ends up in-the-money. Second, expiration should occur very quickly. The ideal timing is on the Friday one week before expiration. This is a crucial date because, on average, options lose one-third of their remaining time value between Friday before expiration and Monday. This is when a single trading day passes but three calendar days pass. For example, if you sell a naked put for $300 on the Friday before expiration, on Monday, expect it to decline to about $200.

A good example occurred with Amazon (AMZN) on the close of business Thursday Nov. 9 (see “Amazoned” above). It highlights an advantage found with opening naked puts on Friday, Nov. 10 and expiring one week later on Nov. 17.

The price had jumped about $130 two weeks earlier on positive earnings news and a change in the target price. As of Nov. 9, the underlying closed at $1,129.13. Two hours after Friday’s open, the underlying price has dropped to $1,127.50 per share. Options available for trading on Friday after two hours of trading, at the following values:

Strike    Put bid

1,117.50    6.55

1,107.50    3.90

Either of these short puts could be traded. Both expire in one week, and both contain attractive premiums. Assuming $5 brokerage fees, the 1,117.50 strike nets $650 and the 1,107.50 put nets a credit of $385. The selection of one over the other depends on a balance between your risk perception and the premium income. The 1,117.50 strike is $10 below the price of the underlying, at $1,127.50. Thus, the buffer zone is $10 plus $6.50 from premium, for a total buffer of $16.50 and margin requirement of $21,550.

The 1,107.50 strike is $20 below the underlying price, and yields a net of $3.85. So the total buffer is $23.85 and margin requirement of $20,550.

These examples demonstrate that on a high-priced stock such as AMZM, a nice cash flow can be generated with naked puts. However, you have to be willing to post cash in your margin account to take care of collateral. That is 20% of the strike value, minus premium received for selling the put. To calculate margin for any trade, use the free margin calculator offered by the Cboe website.

A case can be made for either covered calls or naked puts. Both offer advantages, but for many traders, the naked put is more desirable. It overcomes the need to hold 100 shares of the underlying, and even with collateral, the leverage is tremendous (20% vs. 50% margin for stock).