Overcoming Fear: Selling Naked Puts with Your Pants On

“My wife was afraid of the dark…then she saw me naked and now she’s afraid of the light.”—Rodney Dangerfield

The first step to overcoming any fear is understanding what you’re dealing with. With short-naked puts, that means understanding the strategy as well as its risks.

To enter a short-naked put, you sell to open a put. It’s “naked” because there is no hedge. No spread. No stock. No nuthin’. Not having the hedge maximizes the premium you receive, but also the risk. Before you jump in, you might want to keep some key criteria in mind.

1) Be comfortable with the cost basis.

Cost basis is calculated by subtracting the credit received for selling any given put from the strike price of said put. Before selling that put, you need to understand it’s possible you could end up long the underlying at that price and be comfortable with that potential outcome.

2) Fear is your friend.

Even when the CBOE Volatility Index (VIX) is low, there are stocks with higher than usual “fear” priced into their options. Adding the Implied Volatility (IV) to a thinkorswim® yearly Chart will give you a quick glimpse at the vol range. (From the Chart, go to Studies > Add Study > Volatility Studies > ImpVolatility.) You may want to consider selling puts when vol is at or near the top end of the vol range.

3) Look for high return on capital (ROC).

Before entering a naked-put trade, determine your minimum acceptable daily ROC as part of your goal-setting. Say your daily ROC number is 0.75%. In the thinkorswim® platform, add “Return on Capital” to your layout in the Trade tab. Then multiply 0.75 by the number of days left until the put's expiration to see which strike provides your minimum acceptable ROC or better. Of course, this number is never guaranteed, but consider it a goal post to run towards.

4) Time is on your side.

Because you’re short an option, time (theta) decay is a good thing for short-naked puts. The idea is that when the option premium deflates, you can buy them back at a lower price. Contracts with 50-65 days left until expiration typically have a sufficient amount of theta decay potential built into it. Since they’re shorter-term contracts, they begin to lose more time premium as each day approaches expiration.

5) Mind the buying power effect.

Naked puts can be a capital-intensive strategy due to the higher margin requirements, which all depends on the price of the underlying. Fortunately, calculating margin isn’t hard to figure out in thinkorswim^®. Once you’ve determined which put to sell from the Trade page, clicking “Confirm & Send” in the order screen will bring up the Order Confirmation Dialog box. This contains the Buying Power Effect of selling any given put. It's a good idea to acknowledge and accept the BP effect before committing to the trade.

So there, you have it. Getting naked doesn’t have to be scary, but as with any strategy, you’ll need an understanding of the potential risks of what you’re doing and some hard-and-fast rules you set for yourself.