Following is an outline on how to analyze stock/s to find a Naked Put position. This is a brief outline, and does not take into consideration your investment goals or personal Risk analysis.
Action: Selling (Writing) a Put option
Expectation: Stock/Market will be Neutral/Mildly Bullish
Profit: Limited to premium received
Loss: Unlimited, however stock price can only retrace to zero. If exercised, maximum loss is the strike price minus the premium received
Breakeven: Strike price – premium received
Description:
The writer (seller) of a put option is obliged to buy the underlying shares, at the exercise price. But only if the taker (buyer) exercises the option. For accepting this obligation, the writer receives and keeps the option premium paid by the taker (buyer). This is whether or not the option is exercised.
Strategy Outline
The Naked Put strategy is one of the higher risk strategies. Profit potential is limited, while Risk (if unattended) can be unlimited. Due to this high risk, this strategy also has a correlation with high returns.
It is a relatively simple strategy to understand. You Sell to Open a put option contract. If the option expires at the end of its term, you profit from the position.
It is a brilliant strategy if a few key guidelines are adhered to. But the complacent trader who does not respect this strategy can lose far more than the money they put into the position.
First, let’s recap what a Put option entails:
The put option contract gives the Taker (buyer) the right to Sell their shares, at a set price, on or before the expiration date. As the option writer (seller), you must buy shares if you are exercised, however, you receive premium from the taker for the contract.
You Sell the option, to receive premium. Because a majority of options expire, there is a high probability you will not have to close the trade before expiration.
If the share price is trading below the strike price of the option contract, there is a high probability you would be exercised, and forced to purchase shares. For this very important reason, we use the Strike price as our Stop Loss Exit point. As Naked Put writers, we do not want to be exercised and forced to purchase shares (unless this is the reason you are entering the strategy – stock accumulation).
FMR Analysts also places profit taking orders on this strategy. If we can close out of this strategy early, we will.
A put option increases in value as the share price falls. It decreases in value as the share price rises. Because we write the position at the crust of Time Decay beginning to affect the option value, we also benefit as time draws closer to the expiration date.
After the position is written, we want the share price to remain steady or to rise in value. This will decrease the value of the put option. If we need to close the position, it will be cheaper for us to Buy to Close.
Remember: we are selling the option before we buy it. Think of it as a “reverse trade”. First we sell the option and receive the premium. We then buy the option and have to pay the premium. For this reason, it stands to reason that if we first sell it at a high price and then buy it back at a low price, we will profit from the difference.
The old saying “Buy low and Sell high” also applies here. Only we Sell first and Buy later.
Naked Put Guidelines
• Choose Fundamentally strong stocks
• Beginners: only write Naked Puts on stock you are willing to purchase, and ensure you have the cash to cover the position
• This strategy relies on Time Decay to profit. Only enter positions between 3 to 6 weeks out from expiration
• Bullish to Neutral trend. Ideally, a stock that is trading in a sideways trading range, preferably after a downwards trend. Upwards trends are ok, but definitely not a downwards trending stock.
• Identify a position where the strike price of the option is below your strongest support level.
• Use the support level as your first point to exit. If the stock price closes below this level, consider an early exit.
• If the share price closes below your option strike price, exit the trade.
• Do not hold the position below the strike price as there is a higher probability to be exercised
• Place a limit order at the lowest possible price (above zero), that you can close the option for. If there is a rally in the share price, you could be closed early for a profit, allowing you to continue writing naked puts for the remainder of that expiration period.
Source: http://www.ArticlePros.com/author.php?Matthew Brown
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