Going 'Naked' Can Be Fun ... And Profitable

Experienced options traders know that the February-May-August-November expiration months offer the least opportunities for making money. Fewer stocks are on that cycle for their initial expiration dates and LEAP (very long term) options area almost never end in any of those four months. That doesn't mean you can't make money with those options, there is simply less to choose from than in other months. Last Friday, May 21, was the monthly expiration day. The data below were my actual option positions set to run out that day (pricing shown was as of Thursday, May 20). I didn't have a ton of positions maturing this month due to the reasons already mentioned. By Friday at 4 p.m. all the puts, plus one set of covered calls shown above, had disappeared without a trace. That is horrible news for the people who had purchased those options. It's the best-case scenario, though, for the traders who sold them. Options is a zero-sum game. Every dollar gained by someone is lost by whoever took the opposite side of the same trade (ignoring fees). The table below details each position's strike price, original premium collected, the number of contracts sold and the final profit earned upon expiration. Four of the puts sold saw the May 21 price close very far above their strike prices. The Vera Bradley $10 puts were a bit closer, at a final price of $10.40. That said, any close of $10 or better was all I needed to reap my maximum profit. How much above ten bucks made no difference at all. Additionally, actual break-even points on the put options were way, way below those strike prices. As of expiration day, the final quotes ended up from 60% to over 103% above the prices needed to avoid losses on the put sales. What was my return on investment (ROI)? I pocketed a cool $18,883 net gain on the whole package of naked put sales. Because the trades were executed in a margin account, with plenty of excess buying power, there were no actual initial cash outlays. Since no shares were ever put to me the $18,883 profit came on a negative cash outlay. Based on that the money earned has an infinite ROI. Some people like to use the theoretical net cost of shares, which could have been exercised, even though they might not have been. On that score, $18,883 on the $80,250 potential worst-case scenario would still equal a very fine 23.5% ROI. The average holding period for the option sales was about six months. That translates into an annualized gain of about 47% on what was a purely theoretical outlay. I'd venture to say that almost anybody would be content to see their long stock positions consistently perform that well. Naked put writing is not for everybody. It does increase leverage, which can work against you in very nasty markets like we experienced last winter and spring. You need to be careful not to overdo your option position sizes. How do you gauge that second rule? Think of your typical dollar amount invested when you buy shares outright. If its $20,000, for example, then only think about selling one contract at $200, two at $100, four at $50, or perhaps eight contracts at a $25 strike price. Always calculate the worst-case outlay before going ahead with any put sales. Naked puts provide immediate income along with significant downside protection. Avoid the urge to play with crappy underlying shares simply because the option premiums appear generous. Stick with solid companies you know will be okay over the time horizons of the option expiration dates you are working with. Don't be afraid to extend your expirations out for months or even a year or two. Profitable companies typically become more valuable over time reducing put writing risk through value creation. Time is the raw material you are selling, and it is free to all of us. The vast majority of option buyers lose money. That means a wide majority of option sellers end up winning in this zero-sum game. Become an option writer. You won't always win, but at trade inception, the odds will always be in your favor.

Going 'Naked' Can Be Fun ... And Profitable

Naked put writing is not for everybody, it can provide immediate income along with significant downside protection -- let's strip the technique down to the basics.

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