How Put Selling Works, Part 2

This is a continuation of an earlier post found here.

A common misperception is that most options expire worthless.  This is not true due to people not exercising their options, but because some puts expire out-of-the-money and if a put is in-the-money, the calls at that same strike are out-of-the-money.  In addition, many traders will close their positions before expiration.  If I am no longer bullish on the stock, I’ll exit my position (buy it back from someone else in the open market) on the last day of trading before it expires, if not sooner.  Even if I’m bullish on a stock that is now ITM, I might buy the put back to keep my cash free and will possibly write (sell) another put at a cheaper price, farther out-of-the-money.

The BIG RISKS include a sharp decline in the overall market and having more stocks assigned to the option writer than he can afford, even if using margin.  A common mistake for beginners or even experienced investors who think they can outwit the market is to sell too many naked puts.  Each investor has to find the right level of comfort with risk taken.  Depending on my feel for where I think the overall market will be I sell puts that, based on their underlying value if assigned, will not be more than 200% of my account balance.  That means that if I have an account balance of $50,000 I will not sell puts on more than $100,000 worth of stock.  Going any deeper will increase the likelyhood of a margin call during a market drop.  If the drop is only temporary, all puts may come back above their strikes and a full profit is kept.  If the drop is sustained, all stocks can be bought without the fear of a margin call which would force and early exit from the positon.

Many people fear naked puts because of the large chance of losing money in with a stock’s decline, but the fear is unwarranted.  Selling naked puts has the same risk/return of selling covered calls.  The upside is limited to the amount of the premium received and the downside is as big as the stock’s price if it goes to zero.  If a put seller does not make as aggresive of a move as I do and only sells puts on stocks that could be paid for with the cash on hand he is assuming no greater downside risk than just buying the stock.  I’d argue the risk is lessened if he sells out-of-the-money because the seller then has a cushion that includes the premium received plus the discounted price of the strike being below the current stock’s price. 

Technorati Tags: naked puts, investing, stocks, options, options strategies, trade, finance