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Strategy in brief: Sell a put option with a certain collateral (normally equal to 30-35% of the current stock price). This strategy like no other resembles selling an insurance against stock price drop.
When to use this strategy: you are moderately bullish and confident that the price will not fall.
Comments:
· Sell lower strike options if you are only somewhat convinced the stock will stagnate or rise.
· Sell higher strike options if you are very confident the stock will stagnate or rise.
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Figure: Sell Naked Put Strategy Example
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Profit: limited to the premium received from sale. At expiration, the break-even point is the strike less the premium received. Maximum profit is realized if the stock settles at or above the strike, and it is equal to the put option premium you initially received if the put expires worthless.
Loss: increases as the stock falls. At expiration, losses increase by one point for each point stock is
below break-even.
Risk: Unlimited.
Reward: Limited.
Margin (collateral): Always required. Collateral is the loan value of marginable securities used to finance the writing of uncovered options. It varies depending on brokerages and equals to approximately 30% of the underlying stock’s market price.
Time value decay: a growing asset. As time passes, the value of position increases because the option loses its time value. Maximum rate of increasing profits occurs if the option is at-the-money.
Advantages of this strategy:
· Higher return. Since you have to keep a collateral on the margin account, the return on the short puts will be higher compared to the outright buying of stocks.
· Get the stock you like at a discount price. If you want to own a stock, but don't want to pay today's price, sell puts. You win whatever happens. If the stock drops, you get to buy it at the exercise price, less the premium you received. If the stock goes up, you get the premium. Moreover, if the stock does not move, you still keep the premium.
· Price pullbacks are less impressive. Psychologically investors will take price fluctuations a lot easier if they know that fluctuations within a certain range do not hurt the principal
· Better downside protection. Even if a stock price goes down, there is an opportunity to minimize losses by rolling down (replacing the option with another one that has a lower strike or a later expiration date).
© "Worry-free Option Trading System" & Stock Markets Institute, 2002 | 
