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Keep Your Pants On: From a Naked Put Sale to a Call Purchase

June 4, 2015
Keep your pants on when trading naked options

The naked put sale: It’s a mainstay of many option-trading veterans who are bullish, or at least not bearish and really don’t think a stock will move much lower. And why not, proponents ask? When options end up out of the money (OTM) and worthless at expiration, the option seller can make money (excluding fees and other costs).

If the market tanks and you’re prepared to buy the stock at a price lower than where it’s currently trading, you can see the allure of using short puts as a means of acquiring shares during sell-offs. Keep in mind that if the stock price drops below the strike price of the put and you get assigned, you will be obligated to purchase the corresponding stock at the strike price when the market price of the stock is lower.

Still, you may get a sense of the popularity of this strategy for those looking to buy stocks when the “crowd” panics. Of course, this only works assuming that your stock comes back above the strike price of your option. There's no guarantee that it will. 

There's more to consider. What if your stock never takes a nosedive, and you don’t acquire shares from the option assignment, and the stock does take off? Then you’re missing out on potential profits that could far outweigh the premium you collected from the put sale. Selling an OTM put gives you the obligation to buy the stock at the strike price of your put. You get the premium in exchange for taking this risk. You face the possibility of being “assigned” on your short option, and therefore would only take on this trade if you’re comfortable with that outcome.

All Things Considered

Here’s what you might not know. If the stock drops below your put option’s strike price, there's a very slight chance you might not get assigned. This is true even at expiration.

That’s right. It’s possible to not get assigned on a put option that’s in the money (ITM)—meaning the strike of the put is higher than the stock price at expiration. Assignment happens when the option holder chooses to exercise the option, or when an option ends up ITM at expiration but in certain rare circumstances, the option holder can request prior to expiration, “Don’t exercise my put option, even if it’s in the money.”

Guess what? That means missing out on the profits should the stock head back north, because you wouldn’t get the stock like you thought. And if the stock keeps going, the regret from missing out can become unbearable. Never fun.

It doesn’t have to be this way, though. It might actually be possible to have your cake and eat it, too. Here’s how.

Turn Call Buyer

Let's say you sold the OTM put at the strike price where you’re comfortable taking the assignment, should that occur. Now, instead of reveling in the premium you just collected, you go ahead and spend that premium on a shiny new call option—OTM, of course. As an example, consider a stock that’s trading at $100. By selling the 90-strike put, which is $10 OTM, you collect $1 in premium. Typically, the $10 OTM call is going to be worth pretty much the same as the put, so you pay $1 to buy the 110-strike call. So now, if the stock takes off without you ever getting assigned, the call can still generate profits that you might otherwise have missed. Of course, if the stock price drops, you could lose the entire amount invested in the call.

Call and put options risk graph

FIGURE 1: RISK TRADE-OFF. The red line depicts the point of break-even and risk surrounding the 110-strike call after selling the 90-strike put. With the stock trading at $100, the left side of the graph shows the loss potential if assigned the stock from the short 90 put. The right side shows the profit potential from the long 110 call. With the stock in between those two prices, the trade breaks even. Chart source: TD Ameritrade’s thinkorswim® platformFor illustrative purposes only. Past performance does not guarantee future results.

You’re still taking the risk that comes with the obligation to buy the stock, but now you’re spending the cash from the option sale to buy a call that can profit if the stock takes off (figure 1). It’s just a trade-off. Of course, you can play with the strike prices and maybe even come up with a trade that still generates a net credit if the call buy is cheaper than the put sale. Keep in mind that the long call isn't a hedge for the short put. It will still be naked and the seller will be responsible for applicable margin requirements. It's not quite as simple as selling the put and pocketing the cash.

Still, it’s a trade idea that might be worth consideration, something that may not be appropriate for all markets or all investors. Consider it another tool when  going naked with put options leaves you feeling too exposed.

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