By Bryan Perry, Cash Machine
A successful option strategy that receives little attention is the selling of naked puts on common stocks.
Nearly all the oxygen goes to the big call purchases on short-term, out-of-the-money contracts that potentially offer the biggest exponential returns. However, such options also make for the riskiest of all options trading strategies, and result in 90% of those types of trades expiring worthless.
For options, as well as any trading strategy that employs the use of a time-wasting asset, the element of time either can be your friend or your enemy. If one is long call or put options with relatively short-term expiration dates, the time value portion of that trade loses value each day, particularly if the option has an out-of-the-money strike price.
Keep in mind that any out-of-the-money call or put option is made up entirely of time value. There is no intrinsic value, and thus the clock is ticking when that trade is executed.
Conversely, when one sells a naked put or call against the value of a common stock, the time value associated with that contract also will erode just the same. But the result is rising profits because that option already has been sold first and is expected to be bought again later at a lower price than the price point at which it was sold. Time is on your side. How cool is that?
Take, for instance, a stock like PayPal Holdings (PYPL), a rising leader in mobile digital payments. The stock broke out to the upside back in May 2017 and has been in a steady up-and-to-the-right trend that has been fueled by a streak of strong earnings reports and high-profile partnerships. It is well positioned in a sector that has powerful secular tailwinds that should continue to catalyze growth.
The stock hit a recent high of $65.24 before taking a breather and pulling back to $62.50. The stock then found support at its 20-day moving average. My two-month price target for the stock is $67 on a purely technical basis and a belief in a market that will maintain its bullish bias.
By selling the PayPal November $62.50 puts for $2.00 per contract ($2.00 per contract = $200 in dollars), a trader who holds the same bullish view of the stock can sell five contracts at-the-money and have his account credited $1,000 immediately.
If shares of PayPal close a penny above $62.50 on Nov. 20, which is when the November options expire, those five contracts will be worthless for the buyer and 100% of that same $1,000 will be banked. If the stock closes below $62.50 on Nov. 20, that same account will be “put” or “assigned” 500 shares of PayPal that will cost about $31,000 in cash or about $16,000 on margin. Thus, it is important to have enough cash or buying power at the ready if there is risk of being put the stock in one’s account.
One contract represents the right to buy or sell 100 shares of the correlating stock. If a person is assigned the stock because of a closing price below $62.50, the $2.00 in option premium is banked and the cost basis of the shares is reduced by $2.00 to $60.50 per share.
It is at that time when one might seek to either keep the stock or sell it at a higher price. What is important is to only sell “naked puts” on a stock that you don’t mind having to own if the short-term price movement goes against you. In the case of PayPal, it is one of the market darlings and makes for a fine hold if need be.
The reason selling naked puts isn’t as sexy as the straight-out buying of calls and puts is because your potential profit is defined up front. The PayPal trade will produce a maximum profit of $2.00 per contract because you are selling first and ideally buying back at a lower price or letting the option expire worthless. For those who want more profit potential, here’s how:
With that same $67 two-month price target in mind, an investor can sell an in-the-money PayPal November $67.50 put for $4.50 per contract, or $450 in real dollars. On the sale of 5 put contracts, one is collecting $2,250 right away. If PayPal stock closes above $67.50 on Nov. 20, 100% of that $2,250 is kept. It is not a bad return for a two-month trade. This is clearly more appealing, but it involves PayPal shares having to rally by five points.
Clearly, this is not a widows-and-orphans’ income strategy. But with the right stocks and some consistently good technical timing, it can be an exciting way for investors to win 80-90% of the time. And that’s exactly what’s happening in my Quick Income Trader advisory. Of all the naked put strategies I’ve recommended, we’re winning on 82% of all recommended trades with an average holding period of less than 30 days.
To find out more about how to profit from selling naked puts in a bull market, click here and get your trading capital working for you in a smart manner that puts time on your side and money in your pocket quickly. That’s why we call it Quick Income Trader. This is what many long-life options pros do every day in their own accounts.
Bryan Perry is an income-investing expert who writes a monthly investment newsletter, Cash Machine.