Now, How Should I 'Put' This ...

Put writing, also defined as shorting naked put options, gets a bad rap from almost all sides. People often say, You're taking on unlimited risk for a very finite potential gain or that use of the technique is sure to damage you. All investing involves risk, even when buying risk-free securities like FDIC-insured certificates of deposit or government-issued bonds. What risk do they have? Inflation risk. The true buying power of the dollar is falling faster than the rates at which those insured vehicles are paying in interest. Having a $100,000 nest egg today feels nothing like it did decades ago, when most things costed much, much less. Understanding why put sellers don't take on unlimited risk is easy, once you realize what put sales represent. Shorting a naked put means standing ready to buy at least 100-shares of a specific stock, at a preset price if asked to by the owner of the option. Here's an example to illustrate that point. XYZ Corp. is trading for $10 per share. Option traders are willing to pay you $ 1 per share ($100 per 100-share contract) for the right, but not the obligation, to force you to buy 100 XYZ shares from them at $10 per share out to June 18, 2021. Your worst-case, net purchase price would be the $10 strike price less the $1 put premium = $9 per share. That number equals the put seller's break-even price if the option is held right through expiration day. Owning 100 shares at a net cost of $9 = $900 maximum risk, and then only if the stock becomes totally worthless. That's it. Put selling thus presents a finite risk that can never exceed your net purchase amount. The idea that they offer unlimited risk is completely wrong. The idea that they offer unlimited risk is completely wrong. Traders who simply bought 100 XYZ at the trade inception price of $10 would have a maximum risk of $1,000. That's $100 higher than the maximum loss for the $10 put option's seller. On expiration day if XYZ closes above $9, the put seller would show at least a small gain. That means he'll win if XYZ goes up, goes sideways or even it drops by no more than 99 cents from its $10 trade inception price. Those possibilities cover the most likely outcomes. Based on that, selling naked puts on carefully selected stocks can be a very low risk play. Now let's see just how profitable put writing can be. The trades detailed below recommended here on Real Money Pro in May. They were actual trades in my own accounts. In the first account, I sold 60 contracts of Vera Bradley Nov. 20 expiration day $5 strike price puts and 10 of VRA's November $7.50 puts. I received an average $1.058 per share for those $5s taking my break-even price down to just below $3.95 per share on my 6,000-share potential commitment. My 10 puts fetched about $2.90 per share or $2,897 for the entire 1,000-share commitment. The second, smaller account shorted 10 more of VRA's November $7.50 puts at a, slightly higher, $2.95 premium. I'm writing this column on Nov. 20. VRA closed at exactly $9, well above both strike prices sold. Add up the three option premiums and you'll see that my total gain upon expiration will be $12,197. In the real world that pays a lot of bills. How much did I have to lay out up front to make that handsome gain? Not one penny. I executed these trades in margin accounts that held enough excess buying power to secure the puts. In the end I collected and kept almost $12,200 without putting up any of my own capital. I had no choice, but to take those profits as time had run out by hitting expiration day. The gains become taxable transactions, which will be reported on my 2020 Schedule D when I file my tax return next April. I also decided to cash out some longer-term put naked put positions on Nov. 20, which were not due to expire until Jan. 21, 2022. Last April I just loved shares of Invesco when they sold for $7.38 per share. The option pricing shown below was in effect that day with IVZ at $7.47. Amazingly, put buyers were willing to pony up $1.60 per share to force me to take it at $5, and $3.40 per share to potentially give it to me at $7.50. Break-even prices, for put sellers, dipped to remarkable levels of either $3.40 or $4.60. How absurd was that? IVZ hasn't changed hands below $5 in more than 20 years. I shorted 10-each of the two put strikes collecting $5,000 in total ($1,600 + $3,400). Meanwhile, by Nov. 20, IVZ had surged by over 100%. As of 12:32 p.m., it sat at $15.69. With about 14 months left until expiration and very cheap closing prices, I chose to close out early at the prices shown below, 10 cents for the $5 strike puts and 40-cents for the $7.50s. The table below details the cash flow on these 10-contract lots for both opening and closing transactions. What I originally sold for $5,000 was closed-out for just $500, locking in 90% of the maximum potential gain, 14-months before expiration. Pocketing that very tidy profit took just under a 7-month holding period. The end result of these two, ultra-conservative IVZ puts sales was a $4,500 profit in less than seven months, on a negative cost of capital. How cool is that? With VRA and IVZ, the total gain realized on Nov. 20 was a combined $16,697. Neither stock ever gave me heartburn during the period I was short their puts. Keep an open mind when deciding if put writing should be part of your investment toolbox.

Now, How Should I 'Put' This ...

Put writing is better than, and not as risky as, you think. Let me explain.

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