Selling naked puts

[dlhunter]

As a strategy to generate above average income (10-30% per year) or lower purchase price on the underlying.
Who's got experience, please share any tips/tricks!

[multimut]

As a strategy to generate above average income (10-30% per year) or lower purchase price on the underlying.
Who's got experience, please share any tips/tricks!

First, let's make sure we're talking the same language. When you say "selling naked puts", I assume you mean writing puts with cash on hand to cover the purchase at the strike price. The alternative of writing puts with no cash available to actually buy the stock if the price drops to strike price is a dangerous strategy that is sure to lead to losses at some put.

If you mean writing cash covered put options (write put and hold cash to cover), then economically, the return profile is exactly the same as covered call writing (hold underlying stock and write call options). So once it is established and agreed that cash covered put writing is economically the same as covered call writing, you can see that it is not an uncommon strategy.

It can provide decent returns, but of course the risk is that if the stock in question goes up a lot, you would have been better off just buying the stock. If this strategy is not well executed, you could end up with a portfolio of not so great stocks (the ones you were forced to buy when the stock price dropped on the put option you wrote), while you would have only gotten modest returns on the star stocks (the ones that shoot up, you only gain the option premium).

So it is a valid strategy, but it is not necessarily the best strategy. A saying I like to quote is that "there are no free lunches in the financial markets". So any strategy has advantages and disadvantages. There is no silver bullet.

[Fox2k]

imo, it really depends on your investment philosophy. I think that selling naked puts is a strategy best used by the longer term investor who truly wants to own the stock at any price, and who is interested in holding it for the long term once he owns it. I don't think I will ever be that investor, and based on the information you provided, that's not your goal either..you're looking for an income strategy, you said so yourself. The problem with selling naked puts as an income strategy is that it is a limited reward, unlimited risk scenario. It only takes one bad trade to put you in a really bad position. That trade will come, and when it does, you will have the choice of liquidating your position for a huge realized loss, or holding on to it hoping it gets back to break-even, which will have a gigantic opportunity cost as you tie up that money waiting for the stock to come back. If you're looking for an income strategy, I would strongly suggest learning about delta-neutral strategies. If you REALLY insist on going the naked put route (sometimes you need to get burned to learn the lesson), then I would suggest considering vertical spreads rather than naked puts. At least that way, when the bad trade does come, your loss will be limited, instead of practically unlimited.

Also be wary of any covered call / naked put service you sign up for. Most of them use flawed formulas to calculate the percentage gain and risk / reward. They will do dumb things like factor in intrinsic value which is completely misleading.

[cheapcanoehead]

Depends on how you go about doing this as to whether it's a good strategy.

I learned my lesson the hard way. I levered up bought 10 contracts at same time and was successful for about 6 months. Made about $4500.00 in 6 months, thought I was a genius. Then I got caught when market went into tailspin last summer and lost huge value over a short period of time. I was stupidly stubborn and didn't buy the puts back to close hoping that the market would turn prior to expiration. Market kept freefalling, eventually I did buy the puts back as I didn't want to hold 1000 shares of one stock when it seemed like the sky was falling. Lost $6000.00 on that trade. Wife took me to the woodshed for that one. It's made me much more conservative/less risk taking. There is a book out I heard on the radio called something like Invest like a girl. I've been meaning to read it. Apparently, it suggests that women take fewer risks don't jump in and out of trades as often and earn better returns then men. I believe it because of my own investing record.
ant
Anyhow I'm getting off track.

Naked put writing can be a good strategy. Some value investors anazlyze a stock and want to buy it on a pull back say at a price 10% less than market. What they can do is sell 1 put at a strike 10% below market and earn some premiums while waiting for the stock to fall. Key here is that the investor wants to buy the stock at the given strike price and the investor isn't getting levered up beyond what he can handle. I made three huge errors when I levered up with 10 contracts.

1) I was more attracted to the option premium I was receiving than the idea of owning 1000 shares of any one stock at the strike price. I new that if the stock price fell by 40% or something in 3 weeks prior to expiration that we could lose big bucks, I just thought that it would never happen in such a short period of time.

2) If I was just taking a long position in a stock I would never buy 1000 shares of any one stock. No diversification. So to use leverage as much as I did with potentially a huge loss that could be taken was stupid.

3) (Should be #1 if we're prioritizing mistakes) Wife didn't understand options trading and although I confessed and admitted my wrongs, I should be involving her in these decisions rather than just thinking we'll make big dollars so she won't care. I was arrogant and stupidly greedy for months when I was making winning trades, then I got humbled big time.

One strategy you can use to limit your losses should you write puts is to cover your puts by buying a lower strike put. This will put a cap on the most you can lose for any one trade. If I ever get the guts to approach my wife about selling puts again, I won't be suggesting naked puts, I'd suggest covering my put trade.

But for now, I'm still gun shy about that conversation. Took me a while to get out of the doghouse. I'm in no hurry to go back.

[cheapcanoehead]

First sentence 2nd paragraph should say sold 10 contracts not bought.

[dgodsell]

Naked put writing can be a good strategy. Some value investors anazlyze a stock and want to buy it on a pull back say at a price 10% less than market. What they can do is sell 1 put at a strike 10% below market and earn some premiums while waiting for the stock to fall.

Nice insight. Ignores the risk of new information coming to market but still a viable investing strategy.

[multimut]

Naked put writing can be a good strategy. Some value investors anazlyze a stock and want to buy it on a pull back say at a price 10% less than market. What they can do is sell 1 put at a strike 10% below market and earn some premiums while waiting for the stock to fall. Key here is that the investor wants to buy the stock at the given strike price and the investor isn't getting levered up beyond what he can handle. I made three huge errors when I levered up with 10 contracts.


Nice insight. Ignores the risk of new information coming to market but still a viable investing strategy.

Yes it is a viable strategy, but as I suggested in my first post, there is no best strategy. There are pros and cons with every strategy.

Observations:
(1) as you learned from experience, writing puts without the cash to cover is asking for trouble. As per my first post, if you are going to do this, you better have cash on hand to cover. ["Cash-covered put writing"]
(2) Also as per my first post, if you look at the payoff profile, cash-covered put writing is NO DIFFERENT from covered call writing. If the stock does not go up or down materially, you are ahead as you collect the premium. If the stock drops a lot, you are behind as you end up holding the stock and the premium didn't compensate you for the price drop. If the stock goes up a lot, you are behind, as you only receive the option premium.
(3) The thought that you can pick stocks you wish to acquire at any price and write puts (while holding cash to cover) is not incorrect, but again, it is no different from actually buying buying the stocks and writing calls. And therefore, the pros and cons are the same. Suppose you are interested in two stocks. You write puts on both. One goes up a huge amount and the other drops a huge amount. You end up gaining only the premium on the one that went up a lot, and you end up holding the loser. Now if the loser dropped for no good reason, and is still a good investment, then maybe it will work out in the end. But if the one that dropped, declined because the outlook for the stock is no longer as good.... then you could end up holding a portfolio of medicore stocks, while for the stars, you only collect the premium and miss out on the much larger reward from the stock rising.

Again, there are no free lunches in the financial markets.

The one thing I don't like is the idea of writing a put and then buying a put at a lower price. Yes, we can all understand the reasoning for this, but everytime you buy and sell, you incure fees, and for options the fees are higher than for stock purchases. So when you start getting into overly complex strategies, I don't think these payoff in the long-term for the average individual investor.

I personally think individual investors are at a disadvantage in trading options, as the professionsals have much more information, tools, experience, and knowledge to assess whether the option premium is high or low based on current conditions.

[t_ginuwine]

75 to 80 percent of all options held through expiration will indeed expire worthless. I like these stats right off the bat when looking at a trading strategy that has a positive expectancy.


Why is the average sit-at-home investor not analyzing endless lists of strike prices seeking the most glowing opportunities for deterioration. Fear and greed-fear of risk, fear of the unknown, and most important, fear of that which is not understood.

"Option selling has unlimited risk" is all that most investors know about the concept. The term unlimited risk is enough to cause most investors to cross it off their list of potential investment strategies without further exploration.

What about greed? The other knock on option selling is that it is slow. It is "boring." It has "limited" profit potential. It goes against most investor's instincts to take an "unlimited" risk for the potential for a limited profit. Most traders, especially futures traders, have been taught from their first trading lesson
that in order to turn a profit, a series of small losses must be accepted to make that one big gain.

[t_ginuwine]

Here is a sample portfolio (http://weeklyoptionsfutures.com/?page_id=62) in how to pull off this strategy. Using deep out of the money options, some as far as 40 to 100pts away on the ES. Selling weekly, monthly, quarterly option premium. You can do this with futures (i.e. ES - S&P500, GC - GOLD, CL - Crude Oil) as opposed to index ETFs ( i.e. SPY, SPX, GLD). There are multiple benefits to doing so, the big one is SPAN margins and the ability to sell deep out of the money options.

There are many downsides. As someone mentioned earlier, limited profit, UNLIMITED LOSS/RISK. One of the big issues is a trader who lacks sufficient knowledge and experience. Typically you see a inexperienced trader get large in size(contracts) relative to their account size, and gets burnt because they didn’t use good risk management. . The key is to understand your potential risk and your potential profit, and to have the discipline to act when your plan demands it. Understanding how options work and what influences the premium is vital to being successful. Without the proper tools and a good grounding you had better not try to trade options, but if you are prepared to work at it, the selling of options can be the most rewarding trading you will ever do.

[Mark77]

I'm not a fan of the options market because your capital doesn't really go towards ownership in an active business, but rather, just goes towards holding some government bonds or otherwise 'risk-free' collateral that is held by the options exchange and/or by your broker as a performance bond for your derivatives bets. The economic 'value' being created for whomever is the issuer of those instruments (ie: the government), rather than for yourself.


Implicitly when you sell an option, you're making the assumption that you're smarter than the other guy who buys the option. Maybe you are. But when firms like Goldman Sachs and other very highly capitalized firms hire legions of computer programmers to write software to essentially take the other side of a mispriced trade, you essentially are betting against them. I'd rather not bet against some of the brightest minds, especially when I can sit back, buy an index fund/ETF, and with the low management expenses, actually outperform most institutional investors.

[t_ginuwine]

I'm not a fan of the options market because your capital doesn't really go towards ownership in an active business, but rather, just goes towards holding some government bonds or otherwise 'risk-free' collateral that is held by the options exchange and/or by your broker as a performance bond for your derivatives bets. The economic 'value' being created for whomever is the issuer of those instruments (ie: the government), rather than for yourself.


Implicitly when you sell an option, you're making the assumption that you're smarter than the other guy who buys the option. Maybe you are. But when firms like Goldman Sachs and other very highly capitalized firms hire legions of computer programmers to write software to essentially take the other side of a mispriced trade, you essentially are betting against them. I'd rather not bet against some of the brightest minds, especially when I can sit back, buy an index fund/ETF, and with the low management expenses, actually outperform most institutional investors.

The firms like Goldman Sachs and other capitalized firms can afford to buy very deep out of the money options as insurance, I have no problem selling it to them.

You are not betting against them. I don't really see any type of competition in this space. You essentially become the insurance company selling premium at low cost.

[multimut]

The firms like Goldman Sachs and other capitalized firms can afford to buy very deep out of the money options as insurance, I have no problem selling it to them.



(as I posted before) I agree option writing is a viable strategy. There are some professional managers who follow a covered call writing strategy. So no doubt it is a viable. But IMHO it is much more of a viable strategy in the hands of professionals, than in the hands of ameteurs.

I disagree that "firms like Goldman Sachs" "can afford to buy very deep out of the money options as insurance". The pros don't need insurance. The pros will buy if it is to their advantage, and they will sell when it is to their advantage. If you are writing options, the buyer may be a pro, or may be another individual.

What the professional will do is that they will SELL options when premiums are high (in their professional opinion), and they will BUY options when the premiums are low (in their opinion). They have much better ability to judge whether the premium is high or low relatively to many more factors than you can imagine. The pros also have the ability to quickly reverse the trade if it is to their advantage, and can monitor prices and premiums every minute of the trading day (option prices are much more volatile than underlying stock prices).

Whereas the individual investors has higher fees in the option market, and higher bid/ask spreads in the option market, and the individual does not really have the knowledge or information required to really judge when the premium is high or low (the typical individual might consider premium relatively to past norms, but that misses out so many other factors that professionals will be able to consider).

MHO the majority of individual investors will not execute an option writing strategy well in the long-run. Yes most options expire worthless, but that alone doesn't make this strategy a winner, as the ones that don't expire worthless are often worth a great deal of money. A few mistakes in option writing can destroy the profits made in the successful trades. And it is the professional that is better able to avoid the costly mistake in option writing.

[command]

If you foresee the stock will go up. Then buy it. You will have the max profit.
If you foresee the stock will go up in short time. Buy calls. you can also limit your loss with buying options.
If you foresee the stock will go up but within a limit. Then sell covered call within the limit ATM.
If you are willing to buy the stock at a lower price then sell naked puts at OTM.
If you dont know where the stock will go but you wanna make safe bet with selling naked options just for low premiums you might get caught on the wrong leg than you will have a big problem.
Selling OTM options is like winning 1 point if the dice comes 1 to 5 but when it comes 6 you lose 6 point.
As long as you make the right bet its no problem.
The problem with selling OTM options is its time wasting with limited profit.
I will strongly suggest you to have idea direction on stock than trade on it.

These are what i learned from my experiences.

[t_ginuwine]

(as I posted before) I agree option writing is a viable strategy. There are some professional managers who follow a covered call writing strategy. So no doubt it is a viable. But IMHO it is much more of a viable strategy in the hands of professionals, than in the hands of ameteurs.

I disagree that "firms like Goldman Sachs" "can afford to buy very deep out of the money options as insurance". The pros don't need insurance. The pros will buy if it is to their advantage, and they will sell when it is to their advantage. If you are writing options, the buyer may be a pro, or may be another individual.



You can't make a blanket statement like "the pros don't need insurance". The whole idea behind options market is so the investments can be hedged. Hedging is very much like buying insurance. In doing so they are protecting their investment from a negative event. When negative event happens, their exposure is reduced if they are hedged properly. Especially now during euro crisis with countries defaulting on their loans. The institutions are always hedged.

It is a viable strategy that can be executed by the individual. All you have to do is understand the fundamentals and risks which will happen by studying the markets.




What the professional will do is that they will SELL options when premiums are high (in their professional opinion), and they will BUY options when the premiums are low (in their opinion). They have much better ability to judge whether the premium is high or low relatively to many more factors than you can imagine. The pros also have the ability to quickly reverse the trade if it is to their advantage, and can monitor prices and premiums every minute of the trading day (option prices are much more volatile than underlying stock prices).

Whereas the individual investors has higher fees in the option market, and higher bid/ask spreads in the option market, and the individual does not really have the knowledge or information required to really judge when the premium is high or low (the typical individual might consider premium relatively to past norms, but that misses out so many other factors that professionals will be able to consider).

MHO the majority of individual investors will not execute an option writing strategy well in the long-run. Yes most options expire worthless, but that alone doesn't make this strategy a winner, as the ones that don't expire worthless are often worth a great deal of money. A few mistakes in option writing can destroy the profits made in the successful trades. And it is the professional that is better able to avoid the costly mistake in option writing.

I disagree, individual investors aren't paying higher fees. To trade 1 ES Future Option Contract costs $1.42 and there are plenty of liquidity. Take a look at the spreads and volume interest of these option chains of product like ES ( S&P 500)

The individual can learn the fundamentals and do their own research. If you know basic statistics, you can analyze which percentage expire worthless, what is the average premium built into the options, how fast time decay works in the premium etc.

I agree, it is very easy to make a mistake if you are not disciplined with risk management and that can be catastrophic for your account. This strategy is not everyone's cup of tea. The profits you make is limited and risk is unlimited, who in the right mind would want to execute this strategy ? :cry: I must be crazy to suggest it.

[multimut]

I post on here in areas in which I have knowledge for entertainment and to share knowledge. This debate is not interesting for me.

I just have a couple of things to say:
Pros DO NOT buy out-of-the-money insurance just because they have capital and and afford to (as you stated). That is the point I am making. There is no way pros NEED to buy options as insurance. They will buy options when they are cheap, and sell them when they are dear. If a pro needs to hedge, they can hedge with options when options are cheap, and they can hedge in other ways (such as dynamic hedging) when premiums are too high. The pros, as pros, are too smart to always buy options if it doesn't make sense to buy options.


The individual can learn the fundamentals and do their own research. If you know basic statistics, you can analyze which percentage expire worthless, what is the average premium built into the options, how fast time decay works in the premium etc.


THe factors you have quoted are the factors that an individual may look at to decide if the premium is high or low. The pros (particularly hedge funds) will look at many more factors and therefore have a huge advantage over the ameteur. Trust me, I know what I'm talking about. You cannot hope to compete with the pros on options. THe pros do not always buy options, but they will happily buy from you when you have underestimated the fair value.

[Fox2k]

Trust me, I know what I'm talking about.

Based on your posts in this thread, I respectfully disagree. :p