It is surprising how widely the option strategy of writing naked puts is advocated. That option strategy is also referred to as writing uncovered puts, or writing cash secured puts, or selling naked puts. If you want to learn how to trade options you need to be aware that some strategies are not so good.
What Is Writing a Naked Put?
When you write a naked put option you guarantee to purchase the underlying stock at the strike price on or before expiration. If the taker or holder of the put option exercises the option, you may be assigned the stock. That would mean that you must take delivery of the stock, and you must pay for that stock at the strike price. The put option will be exercised if the underlying stock price is below the strike price. Therefore, if exercised, you must pay more than the market price to buy that stock. The premium you receive when you write a put option compensates you for the risk that you will be assigned and have to pay too much for that stock. You keep the premium irrespective of whether you are assigned. I argue below that the risk is not worth the premium income.
Why Might You Write a Naked Put?
You might write a naked put to earn premium income, hoping that the option would expire worthless. The option would expire worthless if the underlying stock price remained above the strike price. So you should only write a naked put if you forecast the stock price to remain steady or to rise, and not to fall below the strike price. You should not write a naked put if you forecast the stock price to fall. Therefore it is a neutral to bullish strategy.
It would be wise to choose a strike price such that the option will not come into the money because you hope to keep the premium without being assigned. The strike price should represent a floor or support level below which you believe the stock price will not fall.
If you forecast the stock price to rise you might want to own the stock. You might argue therefore that if the price falls below the strike price, you could purchase the stock at a discount. Writing the naked put locks in a low future purchase price. This logic is flawed. It involves “flaky thinking”.
Flawed Reasoning
The problem is that market sentiment can change during the period after writing the naked put and before expiry. The stock can change from desirable to undesirable from bullish to bearish while you are exposed to the naked put. If the stock price falls below the strike price the stock price is falling. But if you have written a naked put the price shouldn’t have fallen below that level. The falling price renders your bullish forecast wrong. Therefore you should no longer wish to own that stock.
You might have been happy to purchase the stock at the strike price when writing the naked put, while the stock was going up, and when the strike price appeared to be a bargain. But if subsequent events cause the stock price to fall, then the price is going down. The reasons for wanting to own the stock probably no longer exist when you are assigned, which is probably why the stock price is falling.
Pay-Off Diagram
The pay-off diagram below shows the potential profit and loss outcomes of naked put options written over NuVasive (NUVA) stock. The solid line represents the profit and loss outcome at expiration; the lower broken line represents the profit and loss situation today. We might choose such a stock because we forecast the price to rise, and a high implied volatility means we might be paid a good premium to write put options. With the underlying stock at $28.58 (at the vertical cursor), fifty put option contracts with a $25 strike price expiring in thirty-three days time were written for a premium of $1.00 (per share), or a total income of $5000 before brokerage. The strike price was chosen because we forecast that the stock is unlikely to fall below $25. With the stock at $28.58 we have leeway of $3.58 before the price reaches $25. That strike price permits an adverse price excursion down to $25 before the option comes into the money, before our forecast is proven wrong, and before the risk of assignment can materialize.
nuva profit loss
Serious Concern
The first thing you should notice is that if your price forecast is wrong, and the stock price falls, you could lose lots of money. The line slopes down to the left all the way to zero, far off below the diagram. The word naked is used because there is no protection, or cover, against the downside. The worst case loss is the strike price less the premium received, which is $25.00 minus $1.00 = $24.00 per share, or, for fifty contracts, $120,000. That should cause very serious concern.
The term “cash covered” is at best a euphemism which means that if your forecast is wrong you will lose a lot of cash. The only cover you have is your own cash. Normally when we use the word “cover” we mean that risk is covered by a third party. But in a cash “covered” naked put, the term is misleading because you are covering yourself. That’s why your broker will only allow you write the naked put if you have the cash to cover the purchase of the stock if assigned. Being cash covered means you are not at all covered. The analogy would be to have no house insurance because you are covered instead with lots of your own cash.
The second thing you should notice is that profit is capped. The maximum profit can never exceed the $5000 premium income. Although this might seem attractive, it is much more important to consider the reward in proportion to the risk. Ask yourself: would you really ever risk taking a $120,000 worst case loss to make a potential but not guaranteed profit of $5000? Remember: there is no guarantee that the stock price will remain above the $25 strike price. Your forecast could be wrong. Other people are paying you $5000 to entice you to take on that risk. They are paying good money because they seek to offload that risk, in some cases onto the unsuspecting.
There’s More to the Picture Than Profit and Loss
Some argue that the pay-off diagram is identical to the pay-off diagram of writing covered calls. Writing covered calls is an acceptable option trading strategy. They conclude therefore that writing naked puts is an acceptable option trading strategy.
This argument is flawed because there is more to trading than mere profit and loss at expiry. The decisions to buy, write or hold involve considerations not shown on the pay-off diagram.
Despite having identical pay-off diagrams, the underlying reasons for writing covered calls are significantly different from the reasons for writing naked puts. And they are more sensible. Writing covered calls is a bullish strategy, so owning the stock is desirable. You would write covered calls on stock which you already own, and which you intend to keep beyond expiration of the options. Writing covered calls is ideal if you hold stock investments for the longer term. If your bullish stock forecast proves to be wrong and the stock price falls, you should close your covered call position and sell your stock, because you are wrong, and because the stock price is falling. But if the stock price falls and you have written naked puts, you are obliged to buy stock which is falling in the opposite direction to your forecast. Why would you buy a falling stock?
Moreover if you open a covered call position you are entitled to ongoing dividends. The pay-off diagram does not show the cumulative effect of dividends earned beyond expiration.
Unacceptable Risk to Reward Ratio
Our Options21 options mentoring clients know that you should only ever trade if you strictly define and limit your worst case potential loss at all times: before opening the position; and throughout the entire trade. If you don’t control risk at all times, emotion will eventually pollute or override your trading decisions. If you trade stock options you should always strictly limit the worst case loss, and ensure that potential loss does not exceed 2.5% of your trading account. You will eventually go broke if you do not control your risk. The sensible way to trade stock options is with small risk and large reward: not large risk for small reward. The written naked put strategy offers the worst of both worlds. It has unlimited downside risk. And it has limited profit to the upside. The risk to reward ratio of writing naked puts is the wrong way around.
Why Would You Buy a Falling Stock?
The naked put option strategy is irrational. Why would you want to buy a stock whose price is falling? You should only buy stock if you forecast the price to rise, and if the price rises to confirm your forecast. In writing naked puts you should intend not to be assigned. The intent is to earn premium income, and keep all of it. Therefore you should choose a strike price below which you forecast the stock will not fall. If the stock price falls below the strike price the stock is not rising: it is falling. Question why the counterparty would buy your written put. Often they would buy the put in order to protect or hedge their stock investment against a price fall. They will no longer wish to hold the stock if the price falls below the strike price because that means the stock has turned bearish.
Fatal Flaw in The Written Naked Put Option Strategy
The fatal flaw in the written naked put option strategy is the time delay between opening the position and the time when the stock price falls below the strike price. The stock might look attractive to buy when you write the naked put, but things can change subsequently. If sentiment turns negative after you write a put option, and if the stock price falls, you probably might no longer wish to own the stock. The problem is that the written naked put option obliges you to buy the stock, and at a premium to the market. In a sense the option strategy could be viewed as a trick used by others to offload unwanted stock onto you at a premium.
The strike price might look like an attractive purchase price at the time of writing the naked put. But the reality is that if sentiment turns negative and the stock price falls, the strike price is no longer attractive. The fact that it might have been attractive in the past no longer matters. It is irrelevant that the strike price is low compared with a past price. The fact is the strike price is high compared with the present price, so you would be paying too much. The strike price can no longer be attractive if the market price is lower. It is not rational to buy a stock which is not good value now because it was good value in the past.
Paying Too Much For The Stock
If you did decide to buy the stock, why pay more than market price? If the stock price falls below the strike price, and you still wanted to buy the stock, the written naked put obliges you to pay too much. The strike price is higher than the market price. If you really wanted the stock it would be better simply to buy the stock on the market, at a price lower than the strike price, and without the complication and risk of writing a naked put.
Worst Case Disaster
Options can be exercised while the underlying stock no longer trades. Even the “best” companies can be bankrupted and have their stock suspended from trading. Companies fall into administration or receivership every year, rendering their stock worthless. If you wrote naked put options over a stock which subsequently became suspended, you will be exercised and obliged to purchase worthless stock at the strike price. If the stock from the earlier example went bankrupt you would be obliged to pay $125,000 for that worthless stock. Even if the stock had some form of residual value, you would not be able to sell that stock if trading has been suspended.
The Odds Are Against You
The idea of earning premium income by writing naked options is a game of statistics which should only be played by large players. Individuals should not insure houses because they do not have the resources to spread risk across many transactions. Only large insurance companies should insure houses. If you write naked puts sooner or later you will be assigned and incur a very great loss: greater than you can bear. The premium income you receive is compensation for taking on the risk of making a huge loss. The market premiums are high because the market prices in that risk. The risk is real. The premium income is not free: it is fair compensation for taking risk. Would you insure somebody else’s house?
Sleeping At Night
How can anyone sleep at night exposed to a pay-off diagram as that shown above. Can any amount of money compensate for the worry? How many sleepless nights can a premium buy? There are some people who sleep very comfortably because they remain blissfully ignorant of the inevitable financial disaster.
Conclusion
I never write naked puts because it is irrational to risk so much for so little gain, and it makes no sense to pay a price above market to buy a stock whose price is falling. I only buy stock whose price is rising. The premium income earned from writing naked puts is illusory. It is statistically inevitable that sooner or later the writer will suffer a serious loss which will annul all gains, and much more. There is no free income, and the income from writing naked puts comes at a very heavy price. My trading style always allows me to sleep very well at all times.
Copyright © 2010 Nils Marchant, Options21.
Thanks for that, a very comprehensive post!