Naked Puts

Occasionally I'll write about an options strategy and today I thought I'd tackle naked puts. Put options allow the holder to sell stock at the strike price anytime between now and expiration of the option. The person who sold that put option is obligated to buy the stock at anytime at the put holders whim. To be clear either side of the transaction can trade out of their position at any time.

Put buyers are either hedging stock they own or speculating that a stock will drop. Put sellers hope the stock stays where it is or goes up.

One of the first things new options traders are told is that naked options is a very speculative strategy. Like most strategies it can be as risky or conservative as you want to make it.

First I'll go over what can go wrong with naked puts with a real example. On Friday Cree (CREE) dropped over $9 due to bad earnings guidance. The stock went from about $35 to $26 in one day. If you had sold a January 30 put a few weeks ago you might have taken in $100 or so, probably a little less. Now after the drop you might get assigned and have to pay $30 for a stock that is trading at $26, you are down four points. Three points I guess, if you took in $100 to sell the put. A whole portfolio of trades like this and you take a nasty hit. When the bubble was popping there were people with too much exposure to naked puts on companies like Ariba, JDSU and Commerce One.

These stocks were trading at $220 or $230, puts struck at $180 expiring in a year could be sold for a lot of money. Trouble came when these stocks dropped to $50 before expiration. In that example a put seller would be out $13,000. More trouble came when put sellers used leverage to get into these positions. Usually, to sell naked puts you have to put up a minimum of 25% of the cost to buy the stock if you are assigned (the formula is more complex but 25% is a good rule of thumb).

To play this out an account that starts with $20,000 on Jan1, 2000 could have sold four puts in the circumstance from the last paragraph. That person loses $52,000 on a $20,000 investment. That's about as bad as it gets. I know people that misused leverage in exactly this manner.

There is a low impact way to sell puts that is much more conservative (there is still risk). Instead of a four letter stock with a beta of 2 an investor could consider a stock like Toro (TTC). Toro makes lawn equipment, has a good track record and growth looks to be solid but not much of a dividend. Instead of buying the stock you could sell a put for June struck at $75 for $2.10 (that's $210). You may have to buy 100 shares at $75. Instead of keeping just $1875, the approximate minimum requirement, you could keep the entire $7500 in cash in case you have to buy the stock. If you do this trade twice a year you could bring in $400 (net of commission). The $400 is like interest on the $7500, 5.3%. There are two drawbacks to this trade. If the stock cuts in half you will be down about $3000. If the stock doubles your opportunity cost is substantial.

I think its an individual decision whether it makes sense to enter into a trade that has more risk than reward but clearly the TTC trade is a relatively conservative way to sell naked puts. For disclosure I had a lucky trade a year ago on TTC and haven't owned it since but I still watch it on my MyYahoo! page.