Monday, February 11, 2013

Selling Naked Puts Is Not So Risky

I love to sell naked puts.  It is basically selling insurance on a stock.  You are paid to protect a stock from falling below a certain price.  If the stock does fall below that price, than you have to buy the stock at the strike price.  If the stock stays above the strike price, than you keep the premium for having to insure the stock.  This methodology has limited up side potential, but has a high probability of success.   Where if you are the buyer of a put, you have unlimited up side potential, but high probability of losing everything.  

In percentage terms, I would say that 80% of the time you win when selling puts.  20% of the time you lose or the person buying the put wins 20% of the time.  Selling puts is a slow and steady way to make income.  Buying puts is a gamblers bet, hoping that a stock will move in a define period of time.  I rather take the high probability play, than the low probability play.

This is just like poker.  Pocket Aces win 80% of the time in a heads-up situation.  Sure you can play your low pocket pair, but you are hoping to hit a set, which will only happen 12% of the the time on the flop!  Better to have consistent gains then just gamble away your winnings...

Just one thing to remember, never sell more puts than you can actually cover.  You can easily over extend your margin if you sell to many puts and the stock craters.  Basically, be prepared to always have enough capital to cover the entire position, in case the worst happens.  In this way, you would be no worst than just buying the stock at the market.  Actually, if you plan to buy any stock, you are better off selling puts instead and hope the stock gets put to you.  In this way, you get the stock at a cheap price and if the stock does go up, you still made money on the time premium.   In many ways, selling puts is actually safer than buying a stock.

Example:  I sold 2 AAPL 480 puts 3 weeks ago before earnings news.  I got $5/share or $1000 for the puts.  The stock was trading around $515.  Well, AAPL sold off after the news, down over 10% to around $460.  Now my puts went from $5 to $20!.  AAPL traded as low as $445 days afterwards and the puts went as high as $35.  Expiration came and I was forced to buy 200 shares at $480.  Good bye $96K..  I was prepared to buy it.  Heck I was buying a $515 stock for $480, who knew it could drop by $70.  But now Im long the stock.  I held my ground and AAPL has bounced back 3 weeks later to $479 today and now Im actually making a profit!  I also sold some weekly calls against my stock, to further decrease my buy-in.
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