Pitfalls Of Selling Stock Options Like Naked Puts

Often selling naked puts is a trade of small amounts which over months of constantly selling naked puts against stocks can result in reasonable monthly income. However there is nothing worse than selling a naked put for .50 cents and ending up buying it back for $1.50. Repeated losses like that can wipe out months of many small gains. In other words a large loss will wipe out many small gains.

Many investors look at naked puts as "free money", which is not correct. There is nothing free about selling naked puts. As soon as the put is sold I can easily be assigned shares; watch the naked put triple in cost to close if the stock collapses; or end up running repair strategies for months or even years in an effort to regain lost capital. Selling naked puts does not result in "free money".

As well, many investors quote statistics that 80% of options expire out of the money every month. This is definitely true but only because there are literally hundreds of options that are so far out of the money that the chance of them ever being in the money is limited to a black swan type event. The real question is how many NEAR or AT THE MONEY options expire out of the money. These are the options I am selling because these are the options that pay enough premium to warrant having my capital at risk. In this event it is closer to 50/50, so the notion that just by placing a NEAR out of the money naked put trade will be successful is far from guaranteed.

Further, selling naked puts leaves the seller open to large losses should the stock plummet. For example if I had held naked puts on AIG in the fall of 2008, the losses would have been catastrophic. In many cases a naked put seller will do spreads instead in order to protect against such a potential disaster. This is done by selling the higher strike naked put and buying a lower strike naked put. Therefore if a stock like AIG had a spread on it, the loss would have been limited to the difference between the strike sold and the strike bought.

Many investors sell far more naked puts than they can actually handle. Selling too many naked puts is a recipe for disaster. When i first starting selling options, years ago, I was caught up in what I felt were excellent naked put positions. Every so many days I would continue to sell more naked puts and often on the same stock as the stock continued to rise in value. Literally dozens of these trades worked out and I made such great returns that I dreamed of quitting my job and doing nothing but trade options. I thought what a genius I was. Then suddenly I hit a streak where a number of trades did not work out. A stock would pull back and I would wait, confident in my technical charts and my belief that I was indeed a genius. I remember one trade in particular when I was first starting out that I kept selling naked puts as the stock went up AND as the stock came down. In the end my loss was more than $32,000 on just one trade alone. This wiped out 8 months of gains and made me realize that not only was I not the options genius I had thought I was, but that it is not options that are risky, it is the investor who blindly accepts the risk.

My Strategy For Selling Puts On Stocks and Avoiding Assignment

Nonetheless there are often many trades that appear where the premiums are so compelling that I would sell naked puts even if I had no intention of ever owning the stock. After all, selling options is all about gathering income. But these compelling trades still had a lot of risk of assignment.

I therefore turned to paper trading and spent several years establishing a strategy for myself that could be reasonably successful. Over those years I developed guidelines or rules for myself which I found if I adhered to I had a much better chance of a successful option trade.

It is important to always remember that each investor has their own personal goals and levels of risk. I learned through many trades that I could attain far more profitable trades when I sold naked puts on stocks that I would like to own. This was because when a stock I WANTED to own fell placing my naked put into a loss situation, I would not close those puts but be content to "ride out" the whipsawing of the stock. However when selling naked puts on stocks I do not ever want to own, I would close on any downturn in order to either lock in my profit to that point or to avoid what could be a larger loss. Throughout the years of perfecting my strategy I found that FOUR THINGS ALWAYS STOOD OUT.

1. It is important to LOCK IN THE PROFIT by buying back my puts when the profit was there.

2. Stocks, no matter how much technical analysis I did, still could surprise to the downside and quickly.

3. It is important to avoid assignment. This is because, as per this article, I am selling naked puts on stocks I do not care to own and often those stocks can collapse very quickly and leave me holding shares at a strike price that can take months to regain my lost capital.

4. Last was to be realistic in my expectations. Earning 3 and 4 percent every month was just not realistic. Some months wiped out other months. However I did find that 1% a month was realistic and I developed strategies to that end.

My Rules For Selling Naked Puts and Avoiding Assignment
I found that when I sold naked puts with no intention of owning the underlying stock, these became my rules or guidelines. Remember nothing on my site is financial advice or recommendations. Trade at your own risk. My site is for discussion and presentation of my ideas only. Read my full Terms Of Use.
 

1) Sell only on stocks that are in an uptrend. To check this I look at the 10 day Simple Moving Average and compare it against the 20 and 30 day exponential moving average. You can read about the 10-20-30 moving averages trading strategy here. Below is a good example from TD Bank in March 2011.This stock has been in an uptrend since early January 2011 and has been a consistent naked put sell for three months.

2) Try for at least 1% from the option sell. It's important to make at least 1% from the trade in order to justify having my capital at risk. If I am only going to pick up half a percent or less from the trade I have to really consider whether it is worth making a hundred dollars if I have a few thousand dollars at risk of assignment. I try to use 1% as a minimum guideline.

3) Sell one month out. I try to stay away from longer time periods. Stocks can fluctuate a lot, even in a month. The shorter the term to expiry, the better my chance to avoid assignment.

4) Always sell out of the money. I don't want the stock, just the income so there is no point in setting myself up for a possible loss by selling at the money or in the money naked puts, even if the stock is trending up.  Below is the March 31 closing option trades for TD on the TSX. The $82.00 strike makes a compelling trade. It meets my guideline of a short time period and 1% income if I can get filled at .82 cents.

5) I always try to sell on a down day for that stock. As per the example above, TD Bank fell more than 1/2 percent on March 31 and the puts have gone up in value. This would be a good day for selling naked puts.

6) I am never in a rush. I place the price I am content with and wait for a possible fill. There are hundreds of stocks. There is never any point in taking less than I wanted. In the above example I would normally place my ask at .82 cents early in the day and wait for a possible fill. That's 1%. If this trade doesn't work out I am always watching other stocks. There will be another trade so no point in chasing any trade.

7) I like to spread out my contracts between two strikes. For example, as per the chart below if I was going to sell 8 naked puts I would sell 4 at the $82 strike and 4 at the $84. That way if the trade turns, and I have to close the 84, many times the 82 will still end up out of the money. Also sometimes the $82 may not give me the full 1%, but the $84 is giving me more than 1%. Added together, if both of these naked puts work out I am making more than 1% overall. This splitting can assist the overall trade results.

8) Treat selling puts as a business. In business it is never ALL or NOTHING. In a business I set goals and objectives. In a business I set up strategies to reach those goals and objectives. By setting my selling of naked puts as a business, I set my goal firmly at 1% per month and then determine how to make that return but spread the risk over my total capital. For example if I have $30,000 to invest then I need to make $300.00 in the month.

To reach my goal of $300.00 I divide up my capital among various naked put trades. For example, in the chart below I can sell VISA for 1.59 which nets a return of 2.27%. If the chart on VISA (10-20-30 averages as per rule#1) shows an uptrend, then I sell the naked puts. I then look at another stock NOT VISA where I can sell farther out of the money, for example Microsoft, and sell the 22.50 for just .57% return. But by combining the two trades I aim to net a total return of 1%. In other words if I have $30,000.00 and I want to earn 1% this month I need to earn $300.00.  If I can sell 2 VISA $70 strike Naked Puts for $1.59 that equals = $318.00. I have made my quota for the month. Two Visa puts at $70.00 equals just $14,000.00 invested. This leaves me with 16,000 I can still place in trades. I can therefore sell 7 naked puts on Microsoft, farther out of the money at 22.50 for .14 cents for $98.00. My return for the month if both trades work out is $416.00 or 1.3%.  1.3% X 12 months = 15.6% annually. On $30,000 a return of 15.6% is $4680.00. Take this concept one step further and consider if I have $90,000 to use for naked puts and I can realize the same returns as above. This would earn $14,040.00. Now consider $200,000 invested using this strategy. This returns $31,200.00 annually.

Being realistic in my returns and treating my naked put selling like a business has assisted me in being far more consistent, setting goals and establishing strategies. I truly do not care about one trade earning 5% one month and then the next month having a lot of trades losing 2%. I want a steady 1% a month return. By splitting my capital among a variety of trades I can risk a smaller amount at higher strikes on more volatile stocks and the bulk of my capital is being used at farther out of the money strikes on less volatile stocks. (more on volatility in rule number 12 below). I would never do this strategy on the same stock. By splitting up among different stocks the likelihood of a total failure is reduced. Should VISA fall and I have to close the trade, I can possibly still make the trade for Microsoft work out.

Taking this strategy 1 step further, whenever I have a month that works out and the capital is not needed for income, I roll that earned income back into my next month's trade. Basically I am compounding my capital. For example if in this month my 30,000 earns the above trade I will have made $416.00. Next month then I have 30,416.00 to invest. Spread out among the same strategy as above for the same strikes means I would sell 2 VISA $70 strikes for 318.00 and then look around further. With Intel at $20.00 I might consider selling  8 contracts of the $18 strike for .20 cents which earns $160.00. If both trades work out my earnings for this month would be $478.00. I then compound that into the next month making my available capital $30,894.00. By continuing this over months and years I found that instead of 12% a year I was continually earning 15% or better every year and lowering my chance of having a month with a complete wipe out as often if the stocks with better premiums such as VISA turned and I did not make the full amount but had to close early, my lower strikes in most cases worked out.

The higher place strike such as the VISA $70 are in smaller contract sizes. The lower strikes such as Intel at $18.00 or Microsoft at $22.50 are holding the bulk of my capital with less risk of assignment than VISA at $70. With this strategy I am diversifying my trades and reducing my risk of assignment on the larger portion of my capital. Recall the statistic that 80% of options expire out of the money, but that near or at the money are 50/50, I am basically playing the odds by having fewer contracts exposed at closer to At or Near The Money and more naked puts sold further out of the money on different stocks.

9) Learn How To Close and Take The Emotion and Guesswork Out. This was an important step for me. I always found it difficult to close early or even knowing when to close. I experimented with many different percentages. Finally I came up with this method which worked for me.

On the high naked put strikes or the At The Money naked puts I had sold, I take the amount I sold the put for and calculate 75% and I put in an offer to buy back my naked puts at that price good until 2 weeks prior to expiry. I put this offer in immediately after I have sold the naked puts.

For example, if I sold the VISA strike for $1.59 I immediately put in my offer to buy back the naked puts at .40 cents. This takes away all the guess work and emotion from the trade. It forces me to close the trade and lock in my profit. If I close early, then I look elsewhere.

After two weeks if the trade is working in my favor I reduce my offer to buy by 10% per day. For the above that would mean .36 cents on the first day and .33 cents on the second day, etc. If the trade still is in my favor by the week of expiry, I will only close for pennies up until Wednesday. By the Wednesday before expiry I will not close at all barring an unforeseen event.

For my further out of the money naked put strikes I immediately set them up to close for 80% of their value. In the case of Intel at .20 cents that would mean I am willing to close the trade for .04 cents anytime up to the beginning of the second week before expiry. After that I do not close unless something unforeseen should occur.

10) If the trade turns against me, but I have a profit, I close immediately. I always know that should the trade turn, there is a very good chance I will be able to sell the same naked puts or even lower within the same stock within a few days or a week. There is always an opportunity to make another profit. Losses can mount quickly with options. I often found that an option that I could have closed for .08 cents today is .50 cents to buy back, just two days later. I found that often I was closing too late on downturns and my profit was almost gone by the time commissions were taken into account.

11) If I do not have a profit, I close the trade as soon as it is a 20% loss. For example, if I sold VISA $70.00 strike for $1.59 and the trade went the wrong way right from the start, I would put in my offer to close at $1.90. I found overall that 20% was a reasonable loss to take and it did not overall affect my entire year's earnings.

On the farther out of the money naked puts I use 25% as my loss buy back point, which seemed for most of my trade to afford me enough room that if a stock pulled back and then turned and continued higher, I did not end up buying back the puts, only to find out a day or two later than it was the wrong trade to have made.

By following rules 9, 10 and 11, I found that I was more consistent in earning income every month. Some months all the trades worked out and in other months only the furthest out of naked puts did, but the returns on an annual basis kept growing and the losses were minimized.

12) The less volatility in the stock the better. Lower volatility often means a stock has not had large price swings. However lower volatility also means smaller premiums so it is a trade off. For example in the chart below for the same strikes for Toronto Dominion Bank, the volatility is not overly high, but then the premiums are not as great.

In this chart I can see that RIM's volatility is twice that of TD, but the option premiums reflect this as well.

Higher volatility though meant more often I was either buying to close my puts early; having to close early because of a pull back; had more trades with higher losses; whipsawing of the stock.

Lower volatility while it presents lower option premiums also provided me with far more trades that were overall profitable. Being realistic and setting the goal of 1% a month made for much better stock selections when ultimately I did not want to own any stock.

13) I Watch Delta. Finally although there are lots of investors who disagree with me, I found that the greeks as a whole did not really assist in my stock selections and put strike selections. However among the greeks I always look at DELTA. Please don't bother to write me about the importance of the Greeks. I do get it. I understand what Gamma, Theta, etc is all about and why some people love them and wouldn't even trade without them. But honestly, stocks move around a lot more than investors realize. Delta in its simplest of form is a quick way to determine what are your "odds" of the stock reaching your strike point before the expiration of those month's options. In my TD example you can see that the odds of the $82 strike being assigned are below 10%. The $84 strike are 25% or 1 in 4. The greeks change all day long and every day, so honestly I prefer the 10-20-30 to really figure out if a stock is in an uptrend and my chance of assignment are low. But at least Delta helps a bit.

Those are the 13 guidelines I follow when selling puts against stock I do not want to ever own. Remember that losses can be large on any investment or investment strategy. These are the rules or guidelines which I developed after paper trading for many years. I suggest every investor interested in selling puts, paper trade first and establish their own set of guidelines or rules. Every investor has their own risk level and investing goals. It is important to learn what they are before entering into any investment.