Sunday, June 8, 2008

Dangers of naked puts

Naked puts can be extremely dangerous strategies that can make one lose all of their money in the market in a very short time. However there is a way to turn this dangerous strategy to a less dangerous but still profitable situation.

First let me show you what a naked put option is. A put option gives the buyer the right to sell a given stock at a given price on or before a given date. It also gives the seller the obligation to buy the stock at the given price on or before the given date.

When you open a naked put position you sell a put and keep the premium. As long as the stock stays above the strike price you would not have to buy the stock. You would walk away with the profits.

For example if a stock is trading at $86 you could sell the $80 put for say $1. As long as the stock stays above $80 you would profit from that trade. The reason this trade is dangerous is the possible loss you could encounter is very high.

If this stock plummets you could lose up to $80 trying to make $1. Now I know that the odds of the stock going from $80 to $0 in a short time frame are unlikely, but it is still a possibility. The stock might go to $70, or $60. Your maximum loss is huge.

This is why if you sell puts it is safer to do so with a bull put spread. With a bull put spread you not only sell a put but you also buy a lower put for security. An example would be selling the $80 put for $1 and buying the $75 put for $.4. Now your max gain is only $.60 but you cannot lose more than $4.4. This is because you can buy the stock for $75 if you need to.

I will admit that I used to love selling naked puts on stocks. It was a great way to pull out extra money from the markets with the spare money I had. In fact in bull markets I would not care what my risk to reward was. The naked puts seemed to be profitable almost every time.

The stock that made me change my mind on this subject was Well Care health plans (WCG). Some of you might remember what happened with it. It was a strong company in an uptrend. I decided to either sell a naked put on it or a bull put spread. Luckily I choose the spread.

The stock started to go up and it looked as if I would profit. One day out of nowhere it was announced that the top managers in the company where being investigated for fraud. The stock fell from $114 to $42 overnight.

Because I had a bull put spread I only lost a little over $4 on it. But it got me thinking. What if I sold a naked put on the stock, I had a possible profit of only $1.15. Because it fell so fast in 1 day I would have lost $72.

I decided not to trade naked puts again on individual companies. Buying the extra protection and turning the trade into a spread can help you when big surprises like that occur.

To see an example of a bull put spread visit

To learn more about trading in the stock market visit

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