Tuesday, May 5, 2009

MythBusters- Naked Puts

Here's the third installment of our Option Myths Series.

Myth #3: Never Sell Naked Puts!

Although I've already covered selling naked puts ad nauseum, it merits our attention once more (it was one of the myths debunked by our Options Action pals). If you want to peruse previous posts on this strategy, click here.

Rather than rehash the intricacies of naked puts, let's just recap a few key characteristics:

1. If selling Naked Puts is risky, then buying stock is riskier!

2. Naked Puts are synthetic Covered Calls

3. Would you rather buy a stock at the current price, or have someone pay you to buy it at a discount? This can be accomplished by selling naked puts.

4. The two biggest drawbacks to selling naked puts are the limited reward (sucks if the stocks stages a huge rally) and large theoretical risk (can be mitigated by proper position sizing & trade management).

USO has been a recent fave of mine for selling naked puts. Here's a recap of my most recent trade on it:

Trade Rationale: Oil is currently in an uptrend with a symmetrical triangle. I’m anticipating a continuation of the trend (Neutral to Mildly Bullish). I also don’t mind buying shares of USO if it falls.
Strategy: Sell Short term, OTM put options (USO @ $29.65, selling 27 puts):
Sell 5 May 27 Puts for $1.00
Net Credit = $100 x 5 = $500
Max Reward - $500
Max Risk = $2600 x 5 = $13000 (This is merely theoretical risk – Oil is not going to $0 in 5 weeks!)
Exit Strategy
Buyback puts at $.20 or better
Allow assignment if USO drops beneath $27 by May expiration (results in buying 500 shares @ $26 cost basis). Then I could sell covered calls against my long stock position.



Mike said...

Just wondering why you would close out your position at $.20, as opposed to waiting another week or so and collecting the entire premium? Please explain......

Tyler Craig said...

Thanks for your question. I'll answer it in a new post.