Selling puts is one of the favorite strategies for many traders, especially when it comes to naked put options. This strategy lets you earn from selling uncovered puts without owning the asset. It’s straightforward but carries risks, as losses can go big if the market turns. Our guide focuses on managing these risks and finding the best opportunities for selling naked puts. We’ll show you how to use high-IV options and our top scanning tools for selling naked options smartly. What is a naked put? Let’s get started.
Key takeaways
- Naked put options are a strategy where the investor sells put options without holding the underlying asset. While the profit potential is capped, the potential for losses is theoretically limitless.
- Choosing high-IV naked put options with a breakeven point far removed in terms of ATR can enhance the probability of success when engaging in naked puts.
- Option Samurai provides a leading-edge scanning environment for selling puts, incorporating filters related to fundamentals, technical analysis, and specific option metrics.
What is a Naked Put Option?
Selling puts, especially naked put options, is a straightforward strategy that appeals to many investors. So, what is a naked put? At its core, a naked put involves selling put options without necessarily owning enough cash to cover your position in case things go south (which is why your broker will normally ask for a margin guarantee with these trades). This strategy allows traders to collect premiums upfront with the expectation that the stock price will either rise or remain above a certain threshold.
When selling uncovered puts, you receive a premium from the buyer. If the stock stays above the strike price, the option expires worthless for the buyer, and you will be able to pocket the premium as a profit. This simple design shows you the force balance of selling naked options (remember: for every option, there’s a buyer and there’s a seller).
Think of it as if you were an insurance company. The insurance company collects premiums upfront from its contracts, which is a much smaller amount compared to what the insurer could end up paying if a certain negative event occurs (a fire at home, a car accident, etc.). Most of the times, the insurance gets away without making any large payments to the client, keeping the premium for itself. However, from time to time, the insurance company will need to pay and record a loss on that particular contract. This is just what happens with a naked put: you collect a premium for the (often fair) assumption that a stock price won’t go down too much, but sometimes the market enters bearish trends, and you may lose a relatively large amount of money compared to the initial premium.
So, pretty much like we told you with naked calls, naked put options have a potentially unlimited loss risk and a capped profit potential. If we put it this way, the strategy does not sound appealing. However, if you think about the fact that over 90% of the puts end up being worthless at expiration, becoming a put seller suddenly sounds like a smart choice.
The breakeven point for the seller is the strike price minus the premium received. While this provides some cushion against loss, the theoretical risk of loss is substantial, as the stock could drop to zero, rendering the cushion negligible. Traders can find a high-probability trade idea by choosing stocks they are comfortable owning and setting stop-loss orders to minimize potential losses. We’ll tell you more about this later.
In terms of investment approaches, selling naked options like puts is often used as a way to enter stock positions at a lower cost or to generate income on existing portfolios. Even institutional investors (the so-called “smart money”) utilize naked puts as part of a broader strategy, combining them with other options or securities to manage risk exposure effectively.
Also, note that the naked put strategy is quite easy to manage:
- You can always roll your options to either avoid taking a loss that you think would be temporary or to cash out profits while keeping a similar position open for a longer time.
- If you ever get assigned, and you are dealing with a good company with stocks that you’d be confident owning, you can see this naked put as the first step of the popular wheel options strategy.
An Example of Naked Put Option
We generally like to explain every strategy with an example, and this article is no exception. For our naked put option illustration, we’ve chosen Devon Energy (DVN). How did we choose this company? Let’s hold on to that thought and clarify this aspect later in the text.
At a trading price of $50.40, our options screener suggests the potential for selling a $48.5 put expiring in 3 weeks. The profit and loss analysis indicates that for profitability, DVN must remain above $47.96 by expiration. Should it dip below this figure, the seller’s losses will scale linearly with the price decline:
Turning our attention to DVN’s price chart, it’s evident that the stock has comfortably hovered above our breakeven point for several weeks.
This steady performance, coupled with DVN’s solid fundamentals (again, more info on this later), suggests that the recent price dip might be a temporary setback rather than a long-term trend reversal. Thus, going for naked put options in this scenario seems to stack the odds in your favor.
On one hand, this is a strategy with high risk if you consider how little you could earn in a trade compared to how much you may end up losing. However, it would not be fair to evaluate naked puts only this way. If this was really the main feature of a naked put trade, the popularity of this strategy would be much lower than it actually is.
The thing is that it is “natural” (you’ll forgive us the use of this term) to expect a good company to do well over time, which means that, if you are careful, naked puts end up being high-probability trades.
It’s not just about picking a stock at random but selecting one with a strong likelihood of maintaining or increasing its value over the option period.
Selling Naked Puts: Pros and Cons
To give you a complete picture, it’s essential to weigh both sides of employing naked put options in your investment strategy. This approach involves selling puts without owning the underlying stock, aiming to profit from premiums. Here’s a table summarizing the main pros and cons for this strategy (more details below):
Pros
- Immediate Income: Selling naked puts generates upfront premium income, which can enhance portfolio returns.
- Lower Entry Price: If assigned, you acquire the stock at a lower price than the current market value, minus the premium received.
- High Probability of Profit: Often, the underlying stock does not fall below the strike price, allowing the seller to keep the full premium without purchasing the stock.
- Selective Strategy: Investors can choose stocks they are comfortable owning, reducing the perceived risk if required to buy the stock.
Cons
- Unlimited Risk: If the stock plummets, the naked put options seller faces potentially significant losses, as there’s no cap on how far a stock can fall.
- Margin Requirements: Selling naked puts requires substantial margin, tying up capital that could be used elsewhere.
- Market Volatility: Sudden market downturns can drastically increase the risk of substantial losses for your naked put options.
- Opportunity Cost: If the stock price rises significantly, sellers only profit from the premium, missing out on the stock’s gains.
How to Manage Your Risk with Naked Puts
Let’s go back to our naked put options example on DVN. We will show you exactly how we selected this naked put opportunity, integrating advanced tools from Option Samurai. By relying on fundamental data, we identified DVN as a growing company with solid earnings, hinting it’s a sensible candidate for selling naked puts.
How did we choose these naked put options? Look at the output of our scan below:
Note the “Stock Score” column. The three numbers represent, respectively:
- The fundamental score of a company
- The growth score
- The stock technical score
Considering that they range from 1 (low values) to 10 (high values), the fact that DVN currently has 9/7/9 as a score is a pretty solid result.
Next, refer to the column “IV Rank.” Here you will find the percentage of days during the past year in which the option’s implied volatility was lower than the current value. For DVN, we observe an 48.41%, meaning that IV is currently at a relatively medium level (of course, you are free to choose a higher level, but keep in mind that IV is not the only variable involved in the trade).
Why does this matter? Well, high IV generally corresponds to higher option premiums, making it more attractive for selling options. Remember: IV is mean-reverting, which means that high values will inevitably lead to lower ones (and vice versa).
Another aspect we like to consider with naked put options is how far the breakeven price is from the current stock price. Of course, you could simply look at the percentage value a stock needs to drop to put you in trouble, but this is not really fair. In fact, some stocks move more than others, so we prefer to consider the so-called Average True Range (ATR) as a reference point instead. You will find this info in the “ATR on strike” column (in our case, DVN needs to drop by 1.70 ATR to put us in danger).
Furthermore, the “value on strike” function in Option Samurai sheds light on what the stock would be worth upon assignment. For instance, selling a put on dividend-paying stocks shows you the expected dividend yield if assigned, offering a clearer picture of potential returns. This comprehensive approach, combining fundamental insights with practical scenarios and specific value metrics, arms traders with a powerful scan for selecting naked put options.
Option Samurai’s “scenario” option allows traders to visualize potential profits or losses with market movements, like if DVN’s stock moves up or down by one standard deviation. This is another great feature you may want to consider before opening a trade.
The inclusion of an alert feature is another crucial tool; it prompts you when a robust company’s stock dips by a certain percentage, suggesting good naked put options opportunities. Integrating all these functionalities into the scanner equips traders with a highly effective system for managing risks while selling naked options. Our suite of filters is very good for many strategies, but it is excellent for naked puts. You don’t need to take our word for it, just check it out yourself, you can even add trades to the paper trade section to see how they perform over time without risking any capital.
