Trading Options for Income

Note from the author: The Naked Put strategy, discussed here, is only for experienced traders who understand the risks associated with options trading, the largest of which are associated with writing uncovered positions. An uncovered Put option, in particular, is extremely risky because you could be forced to lay out a significant amount of cash to purchase the stock should that stock's price fall below the option's strike price. If the stock's price fell to zero, for example, you would be required to pay the option's strike price which might be substantial. Consequently, the Naked Put strategy requires substantial cash to be held in a brokerage account to cover that possible occurrence.

A Put option acts like an insurance policy for the buyer in much the same way your home insurance protects your home. You, the homeowner (Put buyer) buy the insurance from the insurance writer (Put writer) to protect against catastrophic loss. The insurance writer, on the other side of the transaction, collects the premium and profits from insuring a diversified portfolio of these low-probability losses. Sometimes a hurricane Ivans happens, but far more often the insurance company sits back, collects premium and grows rich (Warren Buffet's road to riches).

Back to Put options, the writer of the Put is paid the option's premium and, for doing so, guarantees the Put buyer that he will buy the underling stock, if asked, at an agreed upon price (the strike price) at any time up to the option's expiration date at the Put owner's discretion. The writer of the Put, in effect, writes an insurance policy for the buyer of the Put: the seller gets the premium (income), and the buyer gets the guarantee that his stock's price can not fall below the option's strike price through the option's expiration date. The Put writer is, in effect, writing insurance for the stock owner. One tip: you'll be more successful if you write Puts on quality stocks (good fundamentals, upwards earnings revision fuel and value left at the current price) that are pulling back or consolidating recent gains. Consider the following NTES trade.

Writing Out-of-the-Money Naked Puts for Income

On Friday (3/15/09), I wrote 10 contracts of June $27 Puts for NTES (shown by the red arrow on the chart; then trading at $30.70) and received $0.60 a share or $600 for guaranteeing to buy 1,000 shares (each contract controls 100 shares) at $27 at any time between now and the 3rd Friday in June (26 trading days). In my IRA account, $27,000 was frozen to establish the guarantee. A margin account would require a fraction of this amount. Too, one could buy a less expensive Put, say the June $25, to complete a bullish Put credit spread trade that freezes far less cash in your account.

So what are the risk/reward scenarios for this trade? Well, first, if NTES were to fall in value, I have $4.30 (14.0 percent = ($30.70 - $27 + $0.60)/$30.70)) downside protection, i.e., I'll make money even if today's price falls as much as $4.30 over the next 26 trading days. Of course, the risk protection rises the more in-the-money the Put that you're writing or the greater its implied volatility (volatility expected over the life of the option).

On the other hand, if NTES' price were to rise, as it's more likely to do given its current technical consolidation pattern supported by its rising 20-day moving average, my Puts would expire worthless, and I'd just keep the $600 premium. My reward then would be a 2.22 percent return ($600/$27,000) - or 12 times that annualized. As seen on the chart, NTES had a good earnings report on 5/21; its price rose to $32.16; and the Put position could be closed early at $0.15 for a $450 gain (or held to expiration for the additional $150).

A high portion of the time short in-the-money Put positions, written on quality stocks in pullback or consolidation, expire worthless like this NTES trade did, and when they don't, one finishes owning the underlying stock at a discount equal to its drawdown protection. But this rarely happens (properly chosen, less than 5 percent of the time). In the April expiration cycle, I wrote 133 of these-type Naked Put trades and only three 1,000 share lots were put to me; in the May cycle, I wrote 128 Naked Put trades and again, three 1,000 share lots were put to me. Of course, when shares are put, the next month they become the subject of in-the-money covered Calls and, more often than not, are called away.

A stock's price can do one of five things once you commit to its long side: go up a little, go up a lot, stay flat, go down a little (in NTES' case 14 percent) or go down a lot. Writing out-of-the-money Naked Puts makes money in four of those five scenarios and doesn't lose as much in the fifth scenario (going down a lot) as an original stock owner ($4.30 less loss for the NTES trade). Though most people associate the word risky with option trading, writing in-the-money Naked Puts carries less risk than owning shares of stock.

There you have it, a high-income strategy that's conservative enough to be executed in an IRA once it's set up to trade options. It won't return as much as pure stock ownership in a bullish market (like we've had since 3/6/09), but it will continue to produce good income in a bearish market because of the downside protection. It's actually safer and more conservative than buying stock outright.

Factors That Improve the Odds for Success

First, one needs a method to identify quality stocks to write Puts on, as these will have institutional support. TripleScreenMethod.com (my commercial site with free trials available on request), for instance, uses a set of 16 screens to cross screen the stock universe for three overall criteria: quality fundamentals, earnings revision fuel for immediate upward movement, and remaining value. Performed on the weekend, this screening identifies ~60 stocks for trading in the coming week. Usually, one of these is picked each evening for a long stock trade and Naked Put opportunity.

Second, the stock of interest needs to be in pullback or consolidation mode to an area of support, as this reduces risk substantially. My analysis, as well as that of others like Larry Connors, shows that pullbacks are far more likely to perform than breakouts (e.g., see http://triplescreenmethod.com/TSMNew/Performance/Screens.asp).

Third, the option itself should be liquid enough to have no more than a 30 cent spread in its bid/ask pricing in case one wants to exit the trade.

If you would like a more in depth analysis, access my report at: http://www.triplescreenmethod.com/books/NakedPutReport2009.htm

Richard Miller, Ph.D. - Statistics Professional, is the president of TripleScreenMethod.com and PensacolaProcessOptimizaton.com .