Thursday, June 11, 2009

Mail Time

It's high time for some viewer mail. In response to my Mythbusters- Naked Puts post, Mike asked the following question:

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......

Mike,

Good question. The reason I close Naked Puts when they're almost worthless ($.20 or less), is the same reason I close any other limited reward trade- It gets to the point where the remaining reward isn't worth the risk. To me it is better to just lock in the profits and eliminate any potential of the trade turning against me. It's about being a smart investor, not a greedy one.

Risk-Reward:
Once a naked put is down to $.20 or less, the risk-reward isn't favorable enough to stay in the trade. Ask yourself this- would you enter a new naked put trade if you were only bringing in $.20 premium? Most traders would answer to the negative. It's simply not worth it. Suppose your selling a 1 month 20 strike put for $.20. Your theoretical max risk is $19.80 and your max reward is a measly $.20. It's obviously not worth risking $19.80 to make $.20. Now some would say that $19.80 is merely theoretical risk and odds are pretty slim that the stock drops to $0 within 1 month. That's a perfectly valid point, so let's take the potential risk down to $3.00 instead of $19.80. I still wouldn't risk $3.00 to make $.20.

If you wouldn't enter a new trade that can only profit $.20, then you shouldn't stay in an existing trade with the exact same risk-reward characteristics.

Here are other posts on Naked Puts:

Bottom Line: Although it may be tempting to stay in to eke out the last $.20, in the long run it's usually not worth it.


[Addendum] Krengel Family brings up a good point in the comments section:

"Aside from the risk factor, it is also a good idea to look at the time factor. For example, the money that is going to be held up for margin could be used to open a fresh trade where it will make more over that same period of time, than to grab a few more pennies towards the end of a trade. That is one reason that I like to close them down if there isnt much life left in the trade."

I agree 100%


Tyler-

1 comment:

KrengelFamily said...

Aside from the risk factor, it is also a good idea to look at the time factor. For example, the money that is going to be held up for margin could be used to open a fresh trade where it will make more over that same period of time, than to grab a few more pennies towards the end of a trade. That is one reason that I like to close them down if there isnt much life left in the trade.