Thursday, April 2, 2009

Bare Naked Oil Puts

I wanted to follow up yesterday’s chart of the USO with a strategy overview. The USO had a nice 4 day retracement into a potential area of support. With this price pattern, I'm looking to enter bullish trades. Due in part to the low price of USO, as well as my willingness to accumulate shares at these price levels, let’s assume I sold some April naked puts.

Which Strike:
Choosing which strike price to sell is a matter of personal preference. Most traders sell either at- or out-of-the-money options to increase their probability of profit. The further out-of-the-money the option, the higher the probability of success. Keep in mind that as options move further OTM, they decrease in value. I try to look for the “goldilocks scenario”. In other words, not too close to the current price, yet not so far away that I don’t receive sufficient premium (which for me is around $1). The only times I’ll accept less than $1 are if the stock price is cheapo (like $20 or less). As many of you probably know it’s pretty tough to sell an OTM option on a $10 stock for $1.

Which Month:
Due to the higher theta I stick with selling puts with 2-6 weeks to expiration, which covers either front month or 2nd month options. This is why we chose to sell April puts on USO.

Sell Apr 27 put option for $1
Max Reward = $1
Theoretical Max Risk = $26
Breakeven = $26
Probability of Profit = 1 - .17 = 83%

Are naked puts the best bullish strategy?

Let's answer that by asking this: Can anyone really argue whether or not one strategy or approach is the "best" one?

No siree!

Here’s the deal. There isn’t one right strategy for any situation. It comes down to risk tolerance, account size, personal preference, yada yada yada…
Although naked puts work great in some scenarios, many traders prefer other bullish strategies, such as long calls or bull spreads. I’ll be the first to admit that sometimes naked puts are a crummy way of getting bullish, particularly when the stock skyrockets. Remember short naked puts only afford a limited (and sometimes quite small) reward. Long calls offer unlimited reward.

If after selling a naked put the stock jumps 10% the next day... you bet I’m wishing I bought calls.

But that’s not the point.
The point is I’m comfortable and satisfied with the risk-reward characteristics of a naked put, so regardless of the outcome I shouldn’t be disappointed or second guess myself.


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