Everyone has heard that writing naked or uncovered options is extremely high risk. This is not necessarily true.
The covered call is risky because a stock's value can fall below the net basis (cost of stock less premium received for the call). But when it comes to the naked put, it's a different story. The way to quantify the risk is to realize that a stock's price can only fall so far. Consequently, the market risk involved with naked puts is far less than those of covered calls. You also have to maintain the required margin your brokerage firm needs. This is 100% of the strike value. For example, if the strike is 20, exercise costs $2,000 so margin for one uncovered put is $2,000.
The actual risk of the naked put is not even the difference between current value and zero. The formula is a bit more involved. The risk of the naked put is equal to:
The current value of the stock
Minus: The premium you received when selling the put
Minus: Tangible book value per share
While stock can trade below tangible book value, it is rare and unlikely. So if you want to generate a lot of "rules" to keep in mind:
- You consider the net cost (strike minus premium) to be an exceptionally good price for the stock.
- You are willing to have 100 shares put to you at the strike, meaning you are confident that even with market value below that strike, you think it will come back.
- To avoid exercise, you are able to monitor developments and execute a forward roll or a forward-and-down roll. In other words, take the expiration out another month and, when possible, lower the strike at the same time.
- You are planning to enter into a "recovery strategy" after exercise. Remembering that exercise is going to mean you pay more for the stock than its current market value, you need to wait out the price. As an alternative, you may want to write covered calls to improve your basis. Just be sure that if the covered call is exercised you come out profitably on the other end. The strike of the short call should offset your net paper loss on the exercise of the naked put.
- On a pure cost level, risks are lower for lower-priced stocks. The worst-case risk is a large drop in market value of the stock. So a $20 stock is less risky than a $40 stock for naked call writing.
Why compare uncovered puts to covered call? Because the market risk is identical, but with some notable qualifiers:
--- exercise of a covered call means stock is called away, and the position closes; but exercise of an uncovered put means you have to buy 100 shares at the strike, which will be higher than market value.
--- stock earns a dividend, so a covered call has to include calculation of this additional income.
-- if the stock price rises, the covered call will be exercised (unless you close or roll). But the uncovered put just expires worthless.
-- the biggest difference of all is your ability to close and replace with a roll. You cannot roll a covered call to a position below your net basis in stock, or exercise will result in a net overall loss. But with an uncovered put, you can close and replace without concern for exercise at the strike resulting in a capital loss. As long as you generate net profits, the uncovered put has much greater flexibility.
-- stock can be bought at 50% margin, but the uncovered put requires collateral equal to 100% of the strike. If you have funds on hand, this is not a big issue, but if you do not then you have to tie up more capital with an uncovered put.
For anyone who has spent time studying options and speculating on the basic strategies, it is apparent that the range of potential uses of options is quite broad. So is the risk level, all the way from high-risk to ultra-conservative. This is what makes options so attractive. As you consider a range of possible strategies, whether for swing trading, pure speculation, or as part of a broader portfolio management plan, take another look at the naked put. Even naked, it might not look as bad as you think.