NAKED OPTIONS- PART III
By Michael Craig
SELLING NAKED PUTS
If an investor believes that a stock will increase in value between the current date and the option strike date, he or she may want to sell naked puts. Selling naked puts is a transaction where the investor sells puts on the open market. Selling a naked put means that you have agreed to buy the stock that the put represents from the buyer of the put at a specified price. Of all of the naked options, selling naked puts is the closest strategy to covered calls.
As the stock price that the option call represents goes up in value, the value of the put also goes down. An investor selling naked puts hopes that the option expires worthless. If the option does expire worthless then you have sold the option put for a specified amount and its current value is zero. An example will make this concept clearer.
For example, ABC Stock is trading at $50 a share, and the $50 put is selling for $4 a share. The sale of the put is executed the same as if you were selling a call, except for the fact that you are selling a put. This means that you would sell the put on the open market for $4 a share. If you sold 10 contracts (1000 shares) you would receive $4,000 in your account, even though you did not use any of your “own” money for the transaction.
If the stock price increases from $50 a share to $55 a share, the put will decline severely in value. Also, as the strike date approaches, the option will decline in value, as long as the stock is above the strike price. Since you have sold someone the right to sell you a stock at $50, if the stock is trading above $50 a share on the open market, no reasonable seller will want you to purchase his or her stock. They would simply sell their shares for more money in the open market. If the value of the option falls to zero (and they often do), then the investor has just made $4,000.
However, if the stock decreases in value then the investor could incur substantial losses. If the stock price of ABC goes from $50 a share to $40 a share, then the value of the option call on the strike date will be $10 a share ($50 - $40). The investor is now obligated to purchase 1000 shares of ABC Corp from the owner of the put. While purchasing 1000 shares at $50 a share requires $50,000, the investor can sell the shares on the open market for $40 a share. Therefore the net loss from the purchase of the shares is $10,000. In real life situations this process is completely automated by your broker, and $10,000 is simply deducted from your account. After the $10,000 loss on the purchase of the stock, the net loss on the sale of the naked put is $6,000 ($4,000 - $10,000).
In this example, the price of the stock moved down 20% during the period. However, the change in the value of the option was 150% ((10-4)/4). If the stock had moved down to $30 a share, or a 40% decrease, the option would have increased by 400%, leading to a $16,000 loss for the investor. Since a stock can only fall to zero (and not below), the maximum loss on the sale of a put is the strike price minus the option premium. In the example listed above the maximum loss would be $46,000 ($50,000 - $4,000). Since there may be sizeable losses that the investor where the investor will have to contribute additional capital, investors must get increased option approval status form their brokers, before selling naked puts.
Future segments will continue to explain naked options in greater detail.
This is a segment of the newsletter where we will attempt to answer questions about investing including covered call strategy and procedures. If have any questions about investing or covered calls and NOT about particular stocks send them to michaelc@winninginvestments.com.
Naked Options 
