Ed Note: Selling covered calls and selling puts has always been one of Michael Campbell’s favorite Strategies.
Writing covered calls is one of my favorite ways to generate additional income from stocks already owned, especially if they also pay dividends. That’s because you basically get two cash flows from one stock — without adding any additional downside risk at all.
However, if your goal is collecting additional income without having to sell the underlying shares, the ongoing run-up in share prices hasn’t provided an ideal environment for writing covered calls.
That’s why today I want to talk about another options strategy that can also generate income without undue risk. As you’ll see, this approach is perfect for anyone who wants to get into new positions without “chasing” rising share prices …
Why Going Naked Doesn’t
Always Leave You Exposed!
The strategy I want to talk about today is writing naked puts.
Now, whenever the subject of options comes up, I always stress the fact that investors should avoid writing naked calls. That’s because doing so exposes you to unlimited risk.
However, writing naked puts is a completely different ball of wax.
To see why, let’s recap the general subject of writing options.
When you write a covered call, you already own 100 shares of stock. And you don’t expect the shares to go up substantially over the short term.
So you basically offer another investor the opportunity to buy your shares — at a much higher price than the current rate — during a set amount of time into the future.
In doing so, you collect a nice little premium … which is yours to keep no matter what happens next.
As for consequences, your best-case scenario is that the stock never goes above the price of the options contract you sold. You get to keep the stock (and related dividends) as well as the premium from the covered call.
The worst case is that you have to sell your stock at the contract’s strike price — profiting from both the upside and the premium collected, but missing out on any additional gains beyond the contract’s strike price.
In contrast, if you sell an investor the right to buy shares of stock from you without owning them already, you’re writing an “uncovered” or “naked” call.
And in the event of a massive move up in the underlying stock’s price, you could find yourself losing a lot of money in a hurry. That’s because you’d have to go out and buy the shares at the current price to fulfill your obligation under the options contract.
The critical difference is that PUTS give investors the right to SELL shares at a specific price during a stated time period.
Therefore, writing a naked put is almost like the reverse of writing a covered call …
Options are always in demand, so writing them is a great way to collect income!
You are essentially telling someone that you’d be willing to buy their shares if they fall to a certain level.
The investor buying your “insurance policy” is hedging against potential downside.
And you’re collecting a nice premium upfront!
In short, naked put writing is yet another solid way to get income from options trading.
However, the key here is that you must be ready to take ownership of the underlying stock, too!
As with all options contracts, a naked put covers a round lot of stock, or 100 shares.
So let’s say you want to buy 100 shares of XYZ stock, but you think it’s overpriced at today’s level.
Well, instead of placing a good-till-cancelled limit order with your broker — or watching the ticker tape relentlessly for weeks on end
— you could write a naked put near your buy price instead.
Then, if the stock falls to that level (or below it), odds are very good that the contract holder will “put” his shares to you. And since you also get to keep the options premium, you’ve actually gotten them a little cheaper than you expected!
Alternatively, if the stock doesn’t reach your strike price during the life of the contract, you keep the premium and are free to write another put.
If you keep pursuing the same strategy, you could really make a lot of money just for waiting around!
Of Course, There Are a Couple Things You
Need to Know Before You Write a Naked Put …
First, you could start off with an immediate paper loss when you take possession of your shares.
Second, those losses could be substantial if the price implodes.
Third, you must have enough cash in your brokerage account to cover the potential stock purchase under the put contract.
For all these reasons, I consider naked put writing a bit riskier than covered calls. But in this rising market, it can be a great approach when done correctly.
For more information on the strategy, the Chicago Board Options Exchange website is a great place to start.