Selling naked puts, either cash secured or on margin, is a means for investors to:
- Generate monthly or weekly income on bullish stocks
- Potentially get into stocks at a discounted price
To enter a naked put trade you will will Sell to Open a put option against a specific stock or ETF. An option premium is received up front and the investor now has the obligation to buy shares of that security at the strike price, if the underlying is trading below the strike price at expiration. The investor will generally need to have the capital on hold in their account to fulfill the obligation of the sold put.
This is a neutral to bullish strategy. You should only sell puts against stocks they would not mind owning in their trading account. It is generally not a good idea to sell puts that have a very high premium due to increased volatility on a wildly fluctuating stock. This may result in larger losses that may not match your risk-reward tolerance.
The risk in this strategy is not that you may be forced to buy shares of stock, as you should only be selling puts against securities you would want to own in your account, but that the underlying falls significantly below the put strike price due to an unexpected event. The result of this could be:
- You now own shares that are trading well below the break even
- You may have to pay a much larger premium to Buy to Close the now deep ITM put and attempt to manage the position
- You may be assigned early, forcing stock purchase before you have the chance to manage (roll) the position
So, which strike price is the ‘Best’ when selling a naked put against a security? The strike price is the key decision that controls the risk / reward for the position (Margin requirement if forced to buy stock). When selecting a naked put you should consider the 4 main components that define the risk/reward ratio:
- % to Break Even – this shows the % value the stock can fall before you start losing money on the position. This takes into account the strike price of the put option in relation to the current stock price and the premium received:
[Current Stock Price – (Put Strike Price – Premium)] / Current Stock Price
- % Naked Yield – the % return or interest you receive for selling the put option. The Naked Yield is based on the total margin requirement you may have to have on hold in your account to enter the trade. The % Naked Yield is calculated as:
Option Time Value Premium / Put Strike Price
- % In/Out of the Money – in general naked put sellers will look to sell a put below the current stock price. The range Out of the Money (OTM) gives the investor a sense of the ‘safety cushion’ they have when entering a naked put. The % In / Out of the Money shows how far away the put strike price is from the current stock, as a percentage against the current stock price. The % to Break Even is a better calculation as it takes into account the premium received, however many naked put sellers will look for puts that are at least 3% Out of the Money or so, depending on their tolerance.
% Out of the Money = (Stock Price – put strike price) / Stock Price
- % Probability – the calculated probability or odds that the stock price will be above the put strike price at expiration
The 5th component that comes into play when selecting a naked put strike price is ‘What is my target price for owning the stock?’. We will discuss that a little later on…
If we look at a typical option chain for a stock, the following observations can be made in regard to strike price selection for a naked put:
- As the strike price increases (puts are getting deeper In-the-Money)
- Option Premium increases (though just in intrinsic value)
- % to Break Even decreases
- % Naked Yield decreases
- % Probability above decreases
- As the strike price decreases (puts are getting deeper Out-of-the-Money)
- Option Premium decreases
- % to Break Even increases
- % Naked Yield decreases
- % Probability above increases
|Simplified Apple Inc. (AAPL) @ $97.75 put chain with 24 days remaining to expiration:|
|Put Strike Price
|% Naked Yield||% Out-of-the-Money||% Probability
Middle of the Road – the 97.50 Strike
Based on the numbers above an investor would naturally gravitate to the At-The-Money 97.5 strike. This position offers the highest % Naked Yield of the three transactions. This potential naked put trade is only 0.2% Out-of-the-Money and has just a 51.8% chance of expiring worthless (fully profitable). If AAPL is trading below $97.50, 24 days from now, we may end up owning shares of stock at $95.69; Forced to buy shares of AAPL at $97.50 and discounted – $1.81 option premium received from selling the put.
If this matches your target goals for a naked put transaction and your target price for potential stock ownership, then this would be a good potential trade.
Looking for the Highest Premium – the 100 Strike
We see that the highest premium available is with the In-The-Money (ITM) 100 strike put. If we generated a $3.21 premium against an obligation of $100 (margin requirement), wouldn’t that be a 3.2% yield? Remember the % Yield is calculated based on the time value of the option. The 100 strike put is $2.25 In-the-Money ($100 put strike price – $97.75 current stock price). The option premium of $3.21 consists of $2.25 of intrinsic value and only $0.96 of time value. If the stock remained at $97.75 at expiration we would be forced to buy shares of stock at $100. We keep the $3.21 premium, so our cost per share would be $96.79. This is $0.96 below the current price of the stock, which is why the % Naked Yield is 0.9%.
Could you realize the full $3.21 premium if the stock is trading above $100 in 24 days? Yes, if AAPL was trading above $100 per share the 100 strike put would expire and you would keep the full $3.21 premium. However, there is only a 32.1% probability of AAPL moving above $100 per share in the next 24 days. This would be considered an aggressive and speculative Naked Put trade. A higher premium is received, but there is a lower probability of receiving the full premium.
Playing it Safe – the 95 Strike
The 95 strike put is the furthest Out-of-the-Money and has the highest probability (74.1%) of expiring worthless (fully profitable). This put still offers a good premium and a relatively strong % Naked Yield of 1.0%. If the stock does fall below $95/share at expiration you may end up owning shares of stock at cost basis of $94.08. AAPL stock would have to fall by about 3% in order for the 95 strike put to be ITM at expiration. If the put expires worthless the investor could sell another OTM put against AAPL for the next expiration cycle.
So, which is the best strike price?
This really depends on the investors goals, premium or yield requirement, risk threshold and desired price to own the underlying security. You can choose to be aggressive (In-the-Money), moderate (At-the-Money) or conservative (Out-of-the-Money) for your portfolio.0
As a general rule most naked put investors will sell puts that are At- or Out-of-the-Money, rather than speculate on a sharp rise in the underlying security. In summary we can evaluate the strike price choices this way:
- Conservative – 2.5% or more Out-of-the-Money. These naked puts will offer a higher % to Break Even, a higher % Probability Above but a lower premium and % Naked Yield. An investor will not receive any further credit or premium if the stock moves up higher while the investor is in the trade. This strike selection is used by naked put investors who want the put to expire worthless (fully profitable) on a consistent basis, or have a really low price target for owning the underlying security. However, if you sell a put that is too deep OTM with a high % Probability Above, the option premium and % Naked Yield will be very small and likely will not match your trading plan.
- Moderate – Between 2% Out-of-the-Money and up to 1% In-the-Money. This is the At-The-Money put seller who wants the highest Naked Yield for their expiration time frame, a relatively good % to Break Even and would not mind owning the stock after the first write cycle. The trade off is that the investor realizes there is roughly a 50-50 chance that the ATM put will expire worthless or that the put will be ITM at expiration – meaning the investor will either allow the stock to be put to them or manage the position.
- Aggressive – Put strike is more than 1% In-the-Money. This offers the highest overall premium but a lower % Naked Yield based on the time premium. This offers the lowest % Probability Above, which means a higher probability that the put will be assigned. Investors that sell ITM puts are likely hoping to get put the stock at expiration, for a slightly lower cost basis then if they had purchased the shares out right. This is speculative as the investor will not realize the full benefit of the higher ITM premium unless the stock moves up a fair amount prior to expiration.
Using this method to acquire stock is risky. If the stock price jumps up and the put goes OTM, the stock will not be assigned and a higher price must be paid to enter the stock position. A saving grace is that you did make a little extra on the higher option premium.