Wednesday, June 20, 2012

Naked Put / Calls and Black Swans

seeing some of the traders i follow selling some naked puts and or calls recently so figured id throw my 2cents in the ring.

Selling puts is a valid and profitable strategy when used correctly. its easier to explain by how not to do it, how you can crush your account. i think the biggest mistake is oversizing your position...just making up some numbers here.. lets say AAPL 500 puts are going for $5.00, a cash secured put would require you to set aside $50000 per contract in case you actually got "put the stock" if it closes below 500 on opex. depending on your broker, in a margin account you may not have to put up that much buying power, lets say its only 30% of you might only be required to post $15k of buying power for that put sale. now thats fine, but heres how you get in trouble, if you think of that remaining $35K as free money somehow to be invested elsewhere or worse you sell even more puts , adding 15K per contract of buying power to set aside. if the free 35K is committed elsewhere and AAPL starts dropping you will have to start setting aside more and more buying power, it might come to the point of having to sell other positions or depositing more money. starts turning into a death spiral of sorts.

a common comment is "i only sell puts on stocks im comfortable owning". again thats fine, but the second half of that is to not get shaken out of your position when it moves against you. as in not using stops. if AAPL drops 15bucks in a day then again the next day that put for $5 might now be at $7.50 (paper loss of $2.50).. so your ususal risk managment might say to exit position with a 50% loss...ok sweet, you now have to pay $250 more to close the position..but what happened to the "im comfortable owning this stock" thoughts you had when you entered this cant just say that if the stock moves up. i would argue that you let it ride to opex, let that time decay work for you, and if necessary get put the stock, then start selling covered calls or ratio spreads to make up any loss...remember you said you are comfortable owning the stock? this is the reason i dont use stops on naked puts or credit put spreads, 90% + of the times i got stopped out, the stock closed above the short strike anyway (meaning if i would have held it would have been a profit at opex). there will always be losers but the winners far exceed them.

My suggestions if you are thinking of selling naked puts:
1. Consider each put sale to be a cash secured put.. do not use margin even if you have the bankroll for it
2. Choose stocks to do this that you are comfortable buying lower if it drops.. and actually mean it, cant have it both ways, like it one day, then not the next.. if you are on the fence, dont do it.
3. Consider earnings dates in the timing of put sales, since the IV rise ahead of earnings will negate any time decay.. i said "consider" not "avoid"

as far as black swans, they dont seem to be as rare as they are made out to be.. it will not be a company specific event that does you in, the black swan event will hit your entire account at some time. so if your thinking your blue chip Philip Morris's will be untouched during a crisis, i wouldnt bet on it.. your entire portfolio will get hit along with the margin you think you had as padding.

1 comment:

  1. Good read Mark. If I have that kind of account. I would rather do a Collar trade. Return is less but at least I can sleep at night knowing a protected put will limit the damage.