First, I want to remind you that you have only 1 day, until midnight tomorrow, Monday, May 31 to take advantage of the incredible stock options trading package I offered you a few days ago - scroll to the bottom of this letter to read the details.
Yesterday, I told you why I didn't like writing covered calls. Yet there is a boatload of websites out there recommending that is exactly what you should do.
I could not find any website which advocated selling naked puts as an investment strategy. Yet the truth of the matter is that selling naked puts has the same risk that writing covered calls does (and selling naked puts has some advantages that writing covered calls do not).
What would happen if you sold a naked put (i.e., without owning the stock)? Most people would assume that such a move would be far more risky than writing a covered call. It isnít however. The risk is exactly the same.
If you sold a 60-day naked put (strike price $80 while the stock is at $80), and collected $4, you would gain exactly $4 if the stock goes up by any amount; exactly the same gain you would have enjoyed if you had bought the stock and written a call at the $80 strike.
LetÇs say that after two months, the stock has gone to $85, and you have earned a profit of the $4 you received from the sale of the put. If you then sold an $85 60-day naked put when the stock was at $85, you might collect about $4.25. Let's further assume the stock retreats back to the $80 it was when you started (if you recall, this is the same example we used yesterday when we discussed writing calls).
You would have to buy back the 85 put for $5 at expiration (the difference between the 85 strike price and the $80 stock price), losing $.75 on the transaction. Since you earned $4.00 in the first period, and lost $.75 in the second, your net gain would be $3.25 for the four-month period. If you recall from yesterday's discussion, this is exactly the same gain you would have had if you had purchased the stock and written at-the-money calls.
The same phenomenon exists if the stock should tank. Once the stock has fallen by the amount of the premium you gained by selling the put or call option, you would lose $100 for every $1 the stock falls in value. The maximum possible loss in both scenarios is $80, the price of the stock (since it can't go below zero).
If the financial results are identical, what advantages could there be to selling naked puts over writing covered calls? Many people who write covered calls do it on margin. They purchase the stock and borrow 50% from their broker. Interest rates are low right now; surely lower than the 10% they might make in the above example (and considerably lower than the 30% they fantasize about but will never make).
Buying on margin allows them to almost double their return on investment, since with the original $8000 they needed to buy 100 shares of XYZ, they can now buy 200 shares on margin, and sell 2 calls worth $400 each. Clearly, buying on margin increases the return on investment as long as the stock stays flat or goes up.
Of course, if XYZ falls, the losses can be horrendous. In the extreme case, if the stock falls 50%, you lose your entire investment. Such is the nature of margin.
But covered call writers justify taking the extra risk of margin loans because they select stocks they feel good about; they are confident these stocks will not fall significantly in price. (And probably, they are usually right, unless they are expert analysts, and then they could be terribly wrong).
How would the return on investment compare if you sold naked puts instead of borrowing on margin? The maintenance requirement differs from broker to broker, but a typical requirement would be 20% of the value of the underlying stock. In other words, if you sold a naked put on XYZ at $80, you would have to put up $16 per share.
Making $4 (less commissions and interest) on a $40 investment (margin loan and writing a call) is 10%, while making the same $4 (and taking the same risk) on a $16 investment (maintenance requirement and selling a naked put) is 25%.
And it gets even better. There is no interest on the maintenance requirement, as there is on the margin loan.
Sometimes I wonder why there are dozens of websites advocating writing covered calls and none which I could find that recommend selling naked puts. It must be that people feel more comfortable owning the stock. Call it a warm fuzzy feeling that is both irrational and costly.
What is even better than selling naked puts? My 10K Strategy, of course. This strategy has made over 50% a year several times, in good years and bad, especially if the stock stays flat. It involves buying long-term options (usually calls), and selling short-term options against them (being careful not to sell more options than you own).†
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