The Strategy
If you want to learn to trade here's a really useful option strategy that all traders should and need to know. Let's take a look at an option strategy that involves the selling of a put, often referred to as an uncovered put write or simply a naked put. A naked put is when a trader sells a put that is not part of a spread. This strategy is generally considered to be a bullish-to-neutral strategy.
The maximum profit is the premium received for the put. The maximum profit is achieved when the underlying stock is greater than or equal to the strike price of the sold put. Though this allows for a lot of room for error (The stock can be anywhere above the strike at expiration), note that the maximum loss is unlimited and occurs when the price of the underlying stock is less than the strike price of the sold put less the premium received. So, executing this trade in the right situation is essential. To calculate the breakeven point, subtract the premium received from the sold put's strike price.
The Example
For our example we will use Apple Inc. (AAPL). Apple shares have moved higher since the beginning of July but recently pulled back again. Now the trader thinks after this brief pullback the stock will once again continue to move higher. For this example we will assume the stock is trading around $490 a share at the beginning of September. A trader sells the October 460 put, which carries a bid price of $8.00 (rounded to make the math a bit easier) because there is an area of support at that level that the trader thinks will hold. Should AAPL stock be trading above $460 a share at expiration, the October 460 contract will expire worthless and the trader will keep the premium collected. (Do not forget to take any commissions the trader may pay from the equation.) All is good, right? Well, what if the stock falls below that area of support?
If AAPL falls another $50 to $440 at expiration, the put would expire in-the-money and would have to be purchased back to avoid assignment. This could cost the trader a rather hefty sum. Assigning values, our investor collected $8 in premium. The 460 put expired with $20 in intrinsic value. The trader loses the $20, less the $8 premium collected results in a loss of $12, or $1,200 of actual cash.
Why Sell Naked Puts?
We have already discussed the profit potential of selling naked puts, but there is another reason to do so - owning the stock. Selling naked puts is a good way to purchase at a specific price by choosing a strike near said target price. Should the stock price drop below the put strike and the puts are assigned, the trader buys the stock at the strike price minus the option premium received. Again, should the put not reach the strike price, the premium is pocketed at expiration. Traders should be aware of the risk when selling naked puts and that potential losses can be extreme when compared to other option strategies.
John Kmiecik
Senior Options Instructor
Market Taker Mentoring
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