"An Approach to Successful Stock Trading Combining Company Fundamentals with Chart Technicals"

Monday, May 31st, 2010


Tips on Writing Naked Puts in a Volatile Market

by Richard W. Miller, Ph.D.

          As I write this on May 31, 2010, the world is a mess: We're still fighting two wars, and North Korea is on the brink of another; there's a world financial crisis that worsens daily (our own national debt has grown from 3.18 to 10.64 percent GDP between 2008 and 2010); and at home, there's 10 percent unemployment and no end in sight to the massive oil leak in the Gulf of Mexico.  Having said that, most companies are lean and mean with depleted inventories.  Earnings continue to look good, and as a consequence, the market has been on a tear: between the low on March 6, 2009 and the high on April 29,2010, the S&P 500 gained 76.59 percent before selling off 11.39 percent this past month. Further, 52.6 percent of the 7,102 stocks in the TC2000 data base exceeded the S&P's performance.

          In this report, I’ll restate the conservative approach (1) to earning a 15 to 30 percent return on your money and (2) to buying quality stocks at big discounts in price.  Then offer new tips for today's volatile market.  The strategy is built around selling options (called “writing” options in option jargon):  Naked Puts to generate income or bargain stock purchases.  

Before describing the strategy in more detail, and adding a few selected tips for today's volatile market, let me describe what stock options are for those of you that might have heard of them but never used them or, worse, for those of you who think of them as extremely risky strategies.

 What are Options?

Options are simply contracts, most controlling a 100-share block of their underlying vehicle which could be stock shares or Exchange Traded Funds (ETFs).  Once your brokerage account has been properly activated, options are as easy to buy or sell as the stocks themselves.  However, for all but the most heavily traded stocks and ETFs, the bid/ask spread of an option trade can be much wider than that of its underlying vehicle.  They just aren’t as liquid. 

Today, one can buy or sell (write) option contracts on over one-fourth of  the stock universe, as well as on most indices (as ETFs) and other ETF’s as well, e.g., country, sector specific and even inverse ETFs.  Each such vehicle has its own option string, i.e., a number of different contracts differing in their time of expiration and their strike price.  All effectively expire on the third Friday of their expiration month (technically on the Saturday).  Most can be written for the next several months, while some can be written years into the future (Leaps).

There are two basic types: Calls and Puts.  The value of a Call rises as the price of its underlying stock goes up, while the value of a Put rises as the price of its underlying stock falls.  A whole arsenal of strategies can then be fashioned around simply buying and/or selling Puts and Calls singly or in defined combinations, e.g.,writing Naked Puts or Covered Calls, going Long Calls, writing or buying Debit and/or Credit Spreads, etc . 

Puts give the buyer of the contract the right, though not the obligation, to sell to the Put seller (writer of the contract) the underlying 100  shares of stock at any time up to its expiration date at a specified price (the option’s strike price)—no matter what the price of its underlying stock at the time of the sale.  Conversely, Calls give the buyer of the contract the right, but not the obligation to buy stock from the seller of the Call’s contract at the contract’s strike price.  For these rights, sellers of either option type are paid a premium.  Truthfully, trading options is no more complicated than that, but two analogies should make their usefulness clearer.

A Put’s Similarity to a Home’s Insurance Policy

A Put acts like an insurance policy for the buyer in much the same way an insurance policy protects your home.  You, the homeowner (Put buyer) buy the insurance from the insurance writer (Put writer) to protect against a catastrophic loss.  The insurance writer (like State Farm), on the opposite side of the transaction, collects the premium and profits from insuring low-probability losses.  Sometimes a hurricane Ivan happens, but most times the insurance company sits back, collects premium and grows rich (it’s been Warren Buffet’s road to riches).

Back to Put options, the writer of the Put is paid the option’s premium and, for doing so, guarantees the Put buyer that he will buy the underling stock at an agreed upon price (the strike price) at any time up to the option’s expiration date at the Put owner’s discretion.  The writer of the Put, in effect, writes an insurance policy for the buyer of the Put:  the seller gets the premium (income), and the buyer gets the guarantee that his stock’s price can not fall below the option’s strike price through the option’s expiration date.

For example, if stock XYZ were trading at $50, and one purchased its $50 Put for $3—one that expired in three months—the Put buyer’s betting that between now and three months from now XYZ will finish below $47 before expiration.  The writer of the Put, on the other hand, thinks the underlying will hold its value or rise over the next three months and just wants the $3 for income or, failing that, wants ultimately to own XYZ {trading at $50 today} at the reduced price of $47 if he’s later forced to buy.  The buyer controls that $50 stock for three months at a fraction of its value (just $3 versus $50).  What makes this option trade more risky than shorting the stock outright is that one effectively shorts at $47 a stock today worth $50, but at the same time, less risky is that the total liability should the stock rise say to $75 is again limited to the $3 premium (unlike the full loss experienced by the short seller).

Typically, Puts serve two purposes: (1) someone believes a stock’s price is ready to fall and wants to trade that way, or (2) someone else is holding stock positions that he wants to protect from a fall (i.e., they want to hedge their portfolio)—a kind of insurance if you will.  Those that write Puts do so for the income stream or as a method to buy stocks tomorrow at a cheaper price than available today.  It’s these strategies that are developed in this report. 

Calls give buyers the right, but not the obligation, to buy a stock up to some specified point in the future at a specified price.  They are betting on a price rise in the underlying stock and are leveraging their cost, while sellers again look to generate income.  If the seller already owns the stock on which he is writing Calls, the options are commonly referred to as “Covered” Calls—perhaps the most conservative of all option plays, it’s even available in most IRA accounts.

Now, let me add some prospective to option buying and selling.  Once you understand the probabilities involved in trading options, you will look for strategies that involve selling options to take advantage of the high likelihood for options to expire worthless. 

A study analyzing three years of data (1997-1999), compiled by the Chicago Mercantile Exchange, confirms that option sellers are the winners over option buyers (John Summa, “Option Sellers vs. Buyers:  Who Wins?,” Futures Magazine, March 2003).  His study, based on the option characteristics of five commodity markets (S&P 500 index, Nasdaq 100 index, Eurodollar, Japanese yen, and live cattle), showed that over this three-year period an average of 76.5 percent of all options expired worthless.  Even during this bull market period where prices were rising greatly, 74.9 percent of all Call options expired worthless and 82.6 percent of all Put options did likewise.  Three patterns emerged from the study: (1) three of four options held to expiration expired worthless; (2) the percentage of Puts to Calls expiring worthless depended on the primary market trend; and (3) option sellers were invariably the winners!

With that as an introduction, let’s see how one can mold these Puts into an effective income strategy.  You’ll notice that most calculations ignore commissions ($1 per contract for me). Further, sells are conducted at bid prices and buys are conducted at ask prices.

Tips on Writing Naked Puts in a Volatile Market

          Most successful trading strategies are built around mean reversion where one buys extreme weakness then sells into strength.  While statistics show this approach can be very successful, it also tends to be accompanied by long periods of sitting on cash waiting for those periods of extreme weakness to develop.  Over the past several months, I’ve written about a strategy that can be used to deploy cash at higher rates of return:  writing out-of-the-money (OTM) Naked Puts.  See, for example: Trading Options for Income ; Allocating Money in the Market at Higher Rates of Return.  I’ll further discuss here a trading technique that puts cash to work while waiting for that next trading window.

           Writing Naked Puts, as a strategy, is more conservative than just buying stocks.  Consider, over the next 30 days, a stock’s price can do one of five things:  go up a lot, go up a little, stay essentially the same, go down a little or go down a lot.  The stock owner profits in two of those scenarios, while the Put writer makes money in four of the five and still doesn’t lose as much as the stock owner in the fifth when the “stock falls a lot.”  Albeit, I admit, the latter doesn’t make as much as the stock owner when the stock goes up a lot.  Having made that point, let me offer a few tips on using this strategy in today’s volatile market.

Tip 1:  Write Puts on quality stocks that you wouldn’t mind owning at substantially reduced prices;

Tip 2:  Make sure underlying stock’s price lies above its 200-day moving average, as that’s an indication that this particular stock’s price has not broken down and lost its institutional support;

Tip 3:  Put premiums become richer in uncertain times, as people rush to buy protective Puts, so one can write deeper OTM Puts and still get a targeted return, say 18 percent annualized;

Tip 4:  In an uncertain, volatile market, trade smaller size, demand greater downside protection, and prevent catastrophic losses with a stop loss strategy, one based either on the underlying stock’s price or the option premium itself (e.g., double the premium or a violation of the OTM Put’s strike price, whichever occurs first);

Tip 5:  Trade liquid Puts with bid/ask spreads less than $0.25 in case the trade goes against you and needs to be closed;

Tip 6:  Trade shorter time periods to reduce the risk of further downturn and a potential stop-loss exit, e.g., instead of writing 30-day front month Puts, write them over the last 15 days of the option’s life; realize though, if one required a 1.5 percent return over 30 days (~18 percent annually), he or she still need to get the same 1.5 percent over the shorter period as now there’s 15 days of dead time to carry;  Note, trading the last 15 days of an option’s life is not equivalent to trading 15 days of a longer life option then exiting early because if the market suddenly turns down, volatility rises, premiums inflate and exiting a short OTM position becomes expensive;

Tip 7:  Be particularly aware of when the next earning’s report is because premium inflates as that date approaches; further, the risk of a post-report selloff increases in an edgy market;

Tip 8:  Quality stocks that have pulled back are apt to bounce higher quickly and significantly reduce the premium of a short Put position; as soon as a short put position is created, place a cover order that closes the order when the remaining premium represents less than a seven percent annualized return because that capital can be redeployed at a higher rate of return.

An Example of TSM’s Short-Term Put Writing Strategy

          As an example of trading today’s volatile market, consider BIDU, the provider of Chinese and Japanese internet search services.  Its great fundamentals are evidenced by top rankings from several independent services: Value Line’s Timeliness Ranking (1), Zacks Stock Rankings (1), IBD 100 membership, Morningstar Ranking (10) and a 1.38 VST (Value, Safety and Timing) Vector Vest measure (35th of 10,000 rated stocks).  Too, it has made TripleScreenMethod’s (TSM) list for five of the last 28 weeks. 

          Even so, BIDU has substantial value left at its current price with 0.65 and 0.75 PEG ratios based on the next two year’s estimated earnings growth.  Moreover, this year’s earning’s estimates have been increased: upped 29.5 percent in the last 90 days.  By all accounts BIDU is a great stock to trade, one that will have lots of institutional interest at its major areas of support.


          As shown in the Chart, this past May offered several opportunities to write Puts when, in a volatile market, BIDU’s price  fell to major areas of support (blue arrows marking 5/6, 5/21 and 5/25) following a great earnings report and gap up on 4/29 (horizontal arrow). 

          Table I details possible Naked Put trades. For example, on 5/6 BIDU was trading at $62.50 near the support of its 20-day moving average. Its $59 June Put (expiring in 44 days) could be written for $1.90 per share or its $55 strike, with its increased downside protection, at $0.95 a share.  Either strike falls well below BIDU’s 50-day moving average which is the next likely area of support if price should continue to fall. That first trade scenario represents a 28.39 percent annualized return if held to expiration and an additional 8.64 percent downside protection from the current price.  The second trade represents a 14.68 percent annualized return with 13.52% downside protection. 

          Note, the percent annualized return calculations used here assume that each position would be 100 percent collateralized as would be required for an IRA account, e.g., $5,710 ($5,900 - $190) would be frozen in the brokerage account as collateral for each contract in case a potential buy was necessary should the BIDU shares actually be put to the Naked Put writer.

          But this trade didn’t need to be held to expiration.  Just seven days later, price rose to $82.29, and the short Put positions could be closed for $0.40 and $0.25, respectively.  These amounts represented 6.61 and 4.34 percent returns if the position had been held from that point until expiration 37 days later.  Of course, at this point our cash collateral could be better used collateralizing a different position.

           Short-term BIDU trades presented themselves again on 5/21 and 5/25 and similarly could have been closed shortly thereafter (each within three days) for substantial gains.

          Obviously, in to today’s volatile market, it can pay to manage short Put positions instead of just putting on one and holding it until expiration.  In the BIDU $59 strike series of trades, we increased our profit from $1.90 per share to $3.70 ($1.90 – 0.40 + 1.65 – 0.65 + 1.60 – 0.40) and, at the same time, reduced our exposure to the volatile market’s risk from 44 to 13 days.  That’s a 6.69 percent return ($370/($5,900-$370)) for each contract (or 187.9 percent annualized) earned on money while one waits for the next great stock buying opportunity.

          Most evenings TSM’s daily report provides a list of Puts available for TSM stocks that met the 18 percent annualized return and 15 percent downside protection at the prior day’s close.  These screening criteria lessen as expiration draws near.  Often, the current day’s candidates will be provided intra-day via twitter “tweets.”

Richard Miller, Ph.D. - Statistics Professional, is the president of TripleScreenMethod.com and PensacolaProcessOptimizaton.com.


Copyright 2006 TripleScreenMethod.com
It should not be assumed that the methods, techniques, or indicators presented in these pages will be profitable or that they will not result in losses. Past results are not necessarily indicative of future results. Examples presented on these pages are for educational purposes only. These setups are not solicitations of any order to buy or sell. The author assumes no responsibility for your trading results. There is a high degree of risk in trading. I am not recommending that you purchase or short stocks or options using the techniques and methods presented in this report. Trading should be based on your personal understanding of market conditions, price patterns, and risk. I present here information to contribute to your understanding a technique that has worked well for me.