Monday, March 2, 2009

Trading Naked Responsibly

On Friday’s options action, selling naked puts was in the spotlight. I wanted to throw in my own $.02. Selling naked put is considered a stagnant to bullish strategy. I’ve already highlighted naked puts in a few posts/videos, so you can check those out under the labels section of the blog. In the show they highlighted three considerations for selling naked puts:

1. Price you want to own the stock: Let’s first point out that not everyone that sells puts really wants to buy the stock. Some sell puts simply as a bullish strategy and will always avoid assignment by closing out a losing naked put before it moves in-the-money. Now, assuming your purpose at trade inception was to potentially get assigned and go long the stock, then yes, you most definitely should make sure that you really are willing to purchase the stock at the strike price. This is a bit counterintuitive, as when a stock is trading at $30, it seems like anyone would be willing to buy it at $25… until it actually trades down to it that is. In other words if the stock ends up trading below $25 before expiration, most traders regret having sold the 25 put. So make sure you’re really willing to buy it.

2. Premium: I’m a stickler on this one. I really don’t advocate selling naked puts for pennies. I think the following phrase is applicable here: Don’t pick up pennies in front of a steam roller! In other words, if I were to sell a naked put for $.20. Even if I won 9 out of 10 trades. If on the 10 trade, I end up having to buyback the put at a $1.80 loss, I essentially gave back ALL the gains from my prior nine trades. That being said, make sure you’re bringing in enough premium to make it worthwhile. It’s really personal preference, but for me I like to bring in around $1.00 premium. If the stock is in the teens I may be willing to accept less.

3. Time line: They mentioned (and I agree) selling short term options. First off, it better exploits time decay than long term options. Simply put, short term options have a higher rate of time decay than long term options. Second, shorter term trades afford the stock less time to run amiss.


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