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2011 / Strategy Article - Selling Stock Options
Selling Puts For Profit And Avoiding Assignment
The 13 Rules I Use
Selling stock options for
income is a favorite strategy and selling puts is my first
choice. Naked puts is also often referred
to as selling cash secured puts as the investor will often
have the cash sitting aside to cover the stock price in the
event that the naked puts are assigned. In my mind there is
no difference between referring to them as naked puts or
cash secured puts. It's all semantics. In this article I
will refer to strategy as selling naked puts. Once a put has
been sold, the investor is obligated to be assigned shares
at the strike price they have sold the put for. Basically
they do not own the stock yet, but have indicated their
willingness to own the stock at the strike price they have
sold the naked put at.
What Is Meant When An Investor Sells
A Stock Option Termed Selling
To explain perhaps more
clearly, I will use Toronto Dominion Bank which I refer to
as TD BANK (symbol on TSX and NY is TD) as an example. Today
(March 31 2011) the stock is trading around $86.00. If I
sell a put at the $84.00 strike which expires in MAY I am indicating
that I am willing to own shares of TD Bank at $84.00 ANYTIME
in MAY. Selling this put is a legal obligation to be
assigned shares AT ANY TIME up until the third Friday of the
month of May.
Therefore whether I have the cash readily available or
whether I am going to borrow the money (often called margin)
to pay for those shares, I am legally bound to own shares at
that price. Therefore since I do not yet own the shares I am
NAKED. The term "naked" means that I have exposed myself to
owning shares that I do not yet actually have in my
possession. In other words I am naked the shares as I do not
yet own them. The only way out of this legal obligation
prior to options expiring in MAY, is to buy back the naked
puts which effectively ends the obligation. Of course, if
the stock ends up higher than the naked put strike sold,
then the seller of the naked put retains all the premium
Pitfalls Of Selling Stock Options Like Naked Puts
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.
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
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
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
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.
It is important to LOCK IN
THE PROFIT by buying back my puts when the profit was
Stocks, no matter how much technical
analysis I did, still could surprise to the downside and
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.
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
My Rules For Selling Naked Puts and Avoiding
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.
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.
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.
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
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
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
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.
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.
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.
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.
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
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
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.
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
rules. Every investor has their own risk level and investing
goals. It is important to learn what they are before
entering into any investment.