I frequently speak with traders about various options strategies. Out of all the strategies, the one that gets the strongest negative response is selling naked put options. There’s some type of a connection in many traders minds between naked puts and market corrections that’s very difficult to push aside, because naked put options theoretically, have unlimited risk of loss. Specifically, the difference between the strike price of the put option that you sold and zero, since the price of the stock cannot move lower than that.
In reality however, selling a naked put could be one of the best trading strategies, if at the time the trade is initiated, the put seller actually wants to own the underlying asset at a price that’s substantially lower than the current market value.
If the seller’s primary motive is to profit from selling naked puts as an income strategy, without ever intending to own the underlying asset, then it’s best to avoid the naked put. On the other hand, if you are looking for a strong performing stock and missed a pullback, then the naked put can end up being your best friend.
The process for selling naked puts starts with identifying the strongest stock within the strongest sectors; ensuring that if we are obligated to purchase the stock from the put buyer, we will end up with one of the most resilient stocks possible.
If you want to keep things very simple, without getting into advanced technical analysis; I suggest you begin your search for resilient stocks on the recent list of stocks that are making new all-time price highs and have good amount of liquidity, to ensure that institutions are accumulating the underlying asset.
In the example below, Netflix makes a new high and the relative strength compared to the broad market is very strong. That means that Netflix is outperforming the majority of stocks in the index and the odds of continued momentum to the upside is probable, at least in the short term.
The next step is to wait for the stock to pullback to the downside and fill the gap that was created the $102 and $107 price level, when the stock broke out. Realistically, I’m not expecting the stock to move too much lower, since it’s been very resilient, suggesting that funds are accumulating the stock aggressively on a daily basis.
The next step is to wait for a pullback to the downside, giving the stock time to regain equilibrium, so that it can generate enough momentum to continue trading higher. While there’s a chance that the stock will continue moving higher without pulling back; according to numerous back tests that I’ve performed over the past 15 years, there’s a 65% to 70% chance that a pullback will occur within the next 10 trading days.
When Netflix stock fills the gap or at least partially fills the gap to the downside, as in the Netflix example above, that’s the time to begin looking for naked put selling opportunities. Specifically, I would look for put options that are 1 standard deviation away from the current swing low, using an ordinary Bollinger Band, set to 20 days look back period. I would also make sure that the put option expires in less than 30 days, since we don’t know how long Netflix will maintain such impressive momentum to the upside.
In the example above, you can see the Bollinger Band indicator adjusted to use 1 standard deviation, instead of two standard deviations away from the current price. The 20 day look back period, is the standard setting and doesn’t require any adjustments. In this particular case, one standard deviation away from the current price level, puts the strike price of the option that we would sell close to the $95.50 strike price level, since the low of the Bollinger Band on the day of the analysis was 95.68.
The 95.50 strike price Netflix options that expire on August 21, make good candidates for this trade, since they are the closest strike price to the lower Bollinger Band level and they expire in less than 3 weeks. If Netflix doesn’t reach $95.50 by August 21 or prior to that date, we will end up keeping the entire premium. If on the other hand, Netflix moves below the $95.50 price level, we will be forced to purchase the stock at $95.50.
We sell the August 95.50 put option at $6.25; giving us the opportunity to own Netflix for $89.25 in the case the stock moves lower and we assigned the stock at the $95.50 level over the next few weeks, till the option expires. If the stock trades higher, we would end up keeping the premium and our obligation to purchase the stock at the $95.50 level would come to an end at the time the options expire on the 21st of August – about three weeks away from the present time.
In the present case, Netflix continued gaining momentum over the next 7 trading sessions, trading as high as $129, before selling pressure began.
Because the gain was so rapid and volatility continued to increase, I decided to liquidate the option, instead of waiting for expiration day. I typically close out positions early, instead of waiting for expiration, when the option premium decreases by over 25% over a short period of time.
Since the 95.50 strike price put option lost over 27% in value over the past 7 trading sessions, and the stock’s implied volatility was increasing, which is not good for options sellers, I decided to take profit on the trade, by closing out the put position by buying back the put option that I sold only one week earlier.
While I didn’t get Netflix at the price I wanted, I did end up buying back the option for 27% less than what I sold it for only 7 days earlier. If I held the positions for substantially longer period of time, I would like to make a higher return on risk; but since the position was only held for one week, I considered the profit vs. risk to be reasonable.
I usually focus my attention on the Greeks when I initiate option trades, but in this case, the paramount focus was the underlying stock, since my primary motive was acquiring the stock at a price that’s lower than the current market value. When selling naked put options, focusing on the Greeks instead of the underlying stock is going to get you into trouble very quickly, because Greeks don’t take the relative strength and the resilience of the stock in comparison to other stocks or the overall market into account.
Keep in mind, selling overpriced put option is of little value, if the underlying stock is not desirable at the time the option is sold; since the increase in premium that you will receive from the sale of the put option will not overcome the loss that you will end up taking on the stock, after you end up owning it later on.
In conclusion, you should only sell naked put options, if you plan on owning the underlying stock at a price below market value. Don’t initiate naked put options as a means of generating income; the risk of one major loss will outweigh several profitable trades. Finally, don’t put Greeks ahead of the underlying asset, since the premium received for the trade is less important than the quality of the underlying asset.
Wishing you the best,