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How to Sell Naked Puts for Profit

by | May 17, 2022 | Strategy

The recent market’s higher volatility has made it more attractive to focus on selling naked puts into weakness or using bull put spreads if you prefer to define the risk. The advantage being that even if implied volatility levels just mean revert to lower levels and the stock simply stops declining then the value of put options drops and as a seller of those juiced up premiums you can profit. Instead of buying calls and needing the stock to move drastically higher in a downtrend, as a seller of puts you just want stabilization at the very least which then decreases IV levels, allowing you to buy back the short puts at cheaper prices. Selling puts also is a much higher probability strategy than just about anything with options trading yet so many are worried about the “unlimited risk” aspect which can be easily managed by simply keeping your position size appropriately small. Assuming you are comfortable owning the stock at the strike price you sell, a naked put is the same risk/reward as a covered call and many investors use covered calls to bring in additional yield against common stock they own.

 

What are Naked Puts?

Simply, the term “naked” in options trading just implies undefined risk as a seller. Whether you sell a naked put or call or combine the two to sell a strangle, it’s theoretically unlimited risk because selling an option is an obligation to either buy or sell stock at a strike price. However, since risk can always be quantified based on implied volatility levels, brokerages usually define the “true risk” as the 2 standard deviation levels of the stock and generally require a trader to put up margin or “collateral” equal to that which is usually about 20% of the strike price.

Selling naked puts is a bullish strategy and essentially the same as cash secured puts but with a cash secured put, the trader is putting up the full required capital needed to be assigned shares at the strike price they sold and often hoping to be assigned as a way to enter the stock position at a lower price and be paid a premium for that. You can sell a naked put without ever intending to take assignment of the stock but you better position size accordingly. Some people don’t like selling puts because of the short gamma risk which means the delta grows the more the stock declines. So if you sold an out-of-the-money 40 delta put option expecting the stock to bounce, it can go all the way to 100 delta. Which is why it’s important to trade short puts with the assumption that you can be assigned 100 shares of stock at the strike price and be fine with that risk. If that’s your goal, to own stock you then have the choice to wheel into a covered call and collect more premium that way once you own stock.

You can see from the graph below that this example of AAPL shows the payoff of selling a July 145 put naked. With the stock at 149 and about 2 months till July options expire you can sell the put for 5.75 and collect that premium which gives you a breakeven on the stock under 140 ($145 minus the 5.75 put premium). The nice part about selling a naked put is there are many ways to be right, even if the stock drifts sideways or goes a bit lower but closes above 140 at July expiration then you still profit on the trade. But of course assuming you are willing to own shares at 145 should be the main criteria. The other thing to remember is there is almost no reason to have to wait until expiration to realize a profit. If the stock rebounds sharply then take a 50% profit and call it a win. There is usually never a time where I sit in a winning trade until the week of expiration. In fact, closing a short option when its near 21 days till expiration and rolling or adjusting to a new expiration has been shown to be a solid risk mitigation strategy when managing short options.

 

 

Considerations for Selling Cash Secured Puts

  • Days till Expiration
    • This is always a big question among options traders. Do you sell the front month options that have the highest time decay but also the higher gamma risk if you are off on timing things. Or should you focus on selling options with 45-60 days til expiration or even longer. In general my default will always be further out and prefer to focus on selling naked options or spreads beyond 45 days till expiration. As a put seller you want to give yourself the highest odds of theta decay working for you but also insulate yourself against volatility. By selling an option 3 months out it might seem like too far but remember the goal should be to reduce portfolio volatility and by avoiding gamma risk in the near term options then you can drastically reduce the volatility of your account value. When implied volatility levels in stocks are juiced up like recently in early 2022, you can take advantage of much higher IV in the back month expirations and make the bet that future volatility will subside, as it generally does if you give it enough time. For this reason I would say most retail traders should focus on selling puts in the 45-90 day timeframe.
  • Strike Price and Delta
    • A Lot of traders will default to much further out-of-the-money strike prices to sell options but if you are selling a cash secured put in hopes of potentially acquiring stock then being more aggressive with closer to the money strikes is optimal. If you think about it, when IV levels are higher in volatile markets, the extrinsic value will always be highest at-the-money. So by selling a 40-50 delta put option it can yield much higher returns assuming the trader is bullish and believes the stock is near a floor. All while being able to collect a large premium for the put option. As an alternative I like to incorporate the stock chart and recent support levels based on prior lows or volume profile levels of interest when determining a strike price to sell. If that corresponds to a put option at the 25 or 30 delta then that’s fine. It’s all about having a plan that focuses on removing emotional decisions.

 

A Word on Position Sizing

The biggest mistake traders make with selling puts is doing it too big. Sizing your risk is the most important part of selling naked options and one of the only things you can control when you enter the trade. As a general rule I prefer to not allocate more than 2% of account buying power to a short put trade. Meaning if I have a $100k account I can use $2k of buying power as margin for the short puts I want to sell. Knowing that if assigned stock I will need to set aside about 5 times more than that in cash, based on buying power margin requirements. So this means about $10k of cash needs to be “secured” and available in order to take stock and be assigned if need be. Most times if you are correct on timing your short put you will be able to buy back the puts at a lower price for a profit, without needing to be assigned. That 2% rule per trade I mentioned can be per stock with ideally not allocating more than 10-20% of your whole account into short put trades. So if you picked 5 stocks to sell a cash secured put on, at 2% per trade, you would be at 10% buying power of the total account. This allows you to wait things out and let time work for you, which is half the reason to sell puts to begin with. If you are more experienced then going up a little higher in size is fine too when implied volatility spikes but having a plan is the key.

 

Managing a Short Put Trade

As mentioned above, trying to target 50% profit on short put option trades is a great rule of thumb, meaning if you sold a put at $5.00, then buy it back at $2.50. Especially if that gain happens quickly after entering the trade and there is still a lot of time until expiration. It just doesn’t make sense to keep that amount of risk on the table and see things turn around. Depending on the overall markets and your account risk, it is even fine to take 25-30% profit wins on a short put trade that went according to plan. The high probability aspect of these trades makes it so that you can generally rinse repeat with new strike prices and expirations if you have the same assumptions going forward. The more mechanical you can be with your management of options positions the more consistent you can become and that’s really the goal of this trading stuff. 

 

Takeaways:

  • Selling naked puts is a great way to get long an oversold stock into a key support level.
  • Position sizing small enough is key with selling naked puts and will allow you to have more margin for error.
  • Picking the right expiration date at least 45 days away is a good way to collect enough premium while also reducing gamma risk as an option seller.
  • Focus on targeting 50% profit on a short put trade but even 25% profit if it comes fast in a volatile market.