Today I review two short or â€œnakedâ€ put trades I have talked about this month to show examples of how this option technique can be used successfully to either generate income or to buy your favorite names at a discount. On paper, one of the open trades is a winner, and one is a loser. But even the loser I am very comfortable with and I will explain why in detail.
Weâ€™ll knock out the winner first and review the positive rationale and mechanics for using puts to earn option premium or to establish a buying level for a stock. On June 1 I talked about selling puts on Freeport McMoRan (FCX - Analyst Report) on any weakness because as stock prices fall, put prices rise. I specifically mentioned selling the July 48 put for $2.00 as the stock sold off about 4% on the day.
If FCX is below $48 anytime before July options expiration, the holder of the naked put could be assigned and forced to buy the shares at the strike price, less the initial credit of option premium received. Put-buyers rarely exercise early, but since it can happen at any time and since put sellers are obligated to be long stock up to expiration, the seller of the put must post sufficient margin capital to cover that risk.
In some cases, the margin requirement can be the full amount of the purchase price of the shares, in this case $4,800 per short put contract. But brokers do allow more flexible margin requirements depending on the type of account you have and your option trading experience. See the June 1 article â€œStrategic Put Sellingâ€ for more details.
Earning a $2 Dividend, or Buying FCX at $46
If July expiration comes and FCX is above $48, anyone who sold the July 48 put for $2.00 will keep that option credit as income. In the most conservative way, you could look at this as a 4% return in about six weeks. Not a bad play and better than just about any annual dividend payment you could have earned elsewhere.
On the other hand, if FCX falls below $48 and you are assigned, you would buy the shares at an effective price of $46 because of the $2 option credit received up front. I call that buying the stock â€œat a discount.â€ This scenario may still unfold with stock trading back and forth around $48 with less than three weeks to expiration.
The good news is that you could actually buy this option back today for less than you sold it for, even though the stock is lower than when I recommended the trade and put prices should theoretically be higher. FCX was trading around $49.50 at the time of the initial idea when the put was at $2.00.
Today, with FCX trading as high as $48.50 on the rebound from nearly $47 last week, the July 48 put could have been bought back for $1.60, netting a 40-cent per share profit and eliminating the risk of the naked put position. The primary reasons the option has become cheaper are time, value, decay and lower implied volatility â€“ i.e., risk â€“ in the option price.
Had a large rally occurred in FCX, we might be talking about buying back this option for a quarter or even a dime. Considering stocks have basically sold off for the past few weeks, this isnâ€™t a bad outcome at all to be able to buy it back for a profit if we wanted. Obviously, institutional players feel that FCX is worth accumulating at these levels as well since the stock has found support in the mid-$40â€™s.
Defined Risk, Precision Entry
You can see from the multiple scenarios at your disposal â€“ earn option income, buy stock at a discount, or close options early for a profit (or breakeven, or a loss) â€“ that you have lots of pre-determined control and choices with naked puts. And all of them give you sleep-at-night risk since all outcomes can be envisioned in advance.
And with all the choices of expiration and strike, you can tailor a trade to suit your risk/reward preferences. In the original trade idea from June 1, I also suggested looking at moving down in strike and out in time to capture more premium and lower the near-term risk of assignment by considering the January 45 put for $5. In other words, you get to define â€œsleep-at-nightâ€ risk for yourself.
This makes short puts a powerful tool and weapon as long as you remember that selling them naked carries the same risks as buying the stock, since a significant slide or gap down in shares could virtually guarantee assignment and force you to buy the stock at the strike price, or exit the option for a loss if you choose. In any scenario, itâ€™s exactly like you are selling insurance to the market and you want to make sure you are comfortable with the premium you are getting paid for your risk.
Speculating on Crude With Tolerable Risk
In late May, even as I wrote about the strong probability of a sideways-to-lower stock market for the summer, I was bullish on crude oil and related equities. I took a stand there by selling puts on the United States Oil Fund ETF (USO). I sold the July 39 strike puts for $1.65 on a bet that crude would stabilize near $100 and the USO would stay above $40.
I have done this trade profitably about five other times in the past nine months where I sell a front or second month put to collect premium. I never buy USO calls to speculate on crude because the ETF has severe limitations in its ability to track the underlying commodity and thus the calls donâ€™t appreciate in any meaningful way to make the risk worth it.
Too see what I mean, just pull up a chart of USO and see how it has gone basically sideways between $35 and $40 for two years (the 50-week moving average is $37.77) while crude has launched from $35 to $115 since the credit crisis.
But selling USO puts is a no-brainer to me because I get paid up-front and if crude rallies, I keep the money. If crude goes sideways or even falls, I may still make a profit by buying back the puts as their premium erodes. And in the â€œworst caseâ€ scenario, the ETF falls below my sold strike price and I get assigned to buy the shares.
Which is exactly where I am now since USO is trading below $36 and I am obligated to buy 100 shares of the ETF at $39, less the $1.65 I received in advance. My breakeven here is $37.35 and I am almost $2 in the hole. But Iâ€™m fine with that for a few reasons.
Why Itâ€™s Tactical to Sell Puts
First, that was the bet I was willing to make on crude at the time and I donâ€™t second guess it in hindsight because given the information I had at the time, I would do the same again. I was in good company too as Goldman Sachs had just upped their forecast on Brent for the rest of the year.
Be that forecasting error as it may, it was a global-macro call on a volatile commodity and since I didnâ€™t go â€œall in,â€ Iâ€™m not worried at all about buying it at $37.35 next month when I will likely be assigned. Iâ€™m not worried especially because I see crude above $95 and USO back above $38 in the next six months.
Second, based on my above views, I might actually scale into this position, adding new naked puts at the 36 or 33 strike as we go down or simply sideways. Right now, Iâ€™ll wait and see if we get a bigger swoon in risk appetite that takes equities for a short-term bath and commodities with them. That kind of volatility will certainly bring higher put premiums to capture.
Third, on this particular instrument, the USO ETF, I am very comfortable taking long positions because I know itâ€™s not going to zero. Think weâ€™ll see WTI at $65 again anytime soon, driving USO below $30? Sure, itâ€™s possible but Iâ€™ll be betting against that possibility. And even if it does, I am not worried about USO imploding â€“ barring any â€œblack swanâ€ fund construction or maintenance issues â€“ because unlike an individual company, crude is not going to become worthless anytime soon.
The bottom line here is that every investor-trader could learn to use naked puts as part of their approach to markets. Itâ€™s not a tool for all stocks and all circumstances, but it is a strategic weapon that can be used to tactically define risk and execute buy points in advance. Think of yourself as an insurance company managing global risk and of naked puts as unique buy-limit orders that pay you while you sleep, worry free.
Disclosure: At the time of publication, Cook was short USO puts.
Kevin Cook is a Senior Stock Strategist for Zacks.com
Story Continued....."Anatomy of Naked Put Trades" by Kevin Cook at Zacks.com
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