A naked put strategy allows investors to collect a premium, and potentially purchase stock at a specific price while they wait. The strategy is bullish as investors generally prefer the option to expire out of the money (OTM); however, should the underlying trade below the strike at expiration, the seller will be obligated to buy 100 shares of the stock times at the strike price, times the number of contracts sold. As a result, investors should only ever sell puts on underlying assets they actually like to own.
Three Possible Outcomes When Selling Puts
When selling puts, there are three possible outcomes:
Outcome 1: The underlying security trades below the strike price at expiration, and the option expires “in-the-money.” If this happens, the holder will exercise their right to sell you 100 of the underlying stock at the strike price for each contract sold.
Outcome 2: The put expires “at-the-money,” - meaning the underlying security trades exactly at the strike price at expiration. If this happens, the option expires out of the money, and you keep all the premium.
Outcome 3: The underlying security trades above the strike price at expiration. If this happens, you keep the premium, and the option expires worthless.
As you may have imagined, the preferred outcomes are #2 & #3. However, if the underlying does trade below the strike at expiration, you’ll be forced to buy 100 of the stock at the strike price. That’s why it’s essential to only ever sell puts on stocks you’d actually want to own.
How Much Can Earn or Lose Selling Puts?
The maximum one can earn by selling a put is the initial credit received at the beginning of the trade, known as the premium. The maximum loss, however rare, is the strike price times 100, less the premium collected. I say “however rare” because the underlying would have to drop to zero for the trade to hit this maximum loss condition.
More importantly, however, is the breakeven point. This is the point where the trade will being to either earn, or lose money.
The strategy earns money when the underlying trades above the breakeven point and loses money when it trades below it at expiration.
How to Use Barchart’s Naked Put Screener
Today, I’ll open the Naked Put screener to find a potential trade, and break it down into its working parts.
Days to Expiration: 30-90. Four to six weeks gives me a better balance of risk and reward, allowing me ample time to take profits, cut my losses, or adjust the trade if needed. Weekly expirations are also checked to maximize results.
Security Type: Stock, ETF. By default, “Stock” is checked; however, I’m comfortable selling puts on certain ETFs.
Delta: This tells us how much the premium will move in relation to a $1 change in the underlying security. It’s also a signal that reports the chances the option will expire in the money or not. A 0.20 Delta (a.k.a. 20 Delta) option means it has a 20% chance of expiring “in-the-money” or an 80% chance of expiring worthless.
OTM Probability: I set this to 70% for added safety. The screener will display trades with 70% (or more) of expiring OTM.
Overall Buy/Sell/Hold Signal: This filter is part of Barchart’s proprietary Opinion feature, which uses 13 technical analysis tools to measure a stock’s predicted performance in the short, medium, and long term. I set this filter to look for “Buy” rated companies since I’m looking for quality companies that potentially have a higher target price.
Overall Opinion Direction: The overall opinion direction, meanwhile, indicates whether the signal is weakening or strengthening. I set these to the “Strongest” and “Top 1%.”
Overall Opinion Strength: As the title suggests, this filter measures the underlying strength of the signal compared to its historical performance. I set these to “Strong,” “Max,” and “Top 1%.”
The Results are In
This week’s trade idea considers selling a put option on SPY or the SPDR S&P 500 ETF Trust.
The SPY is one of the more popular ETFs that tracks the S&P 500 Index. It provides exposure to the S&P 500 without investors having to buy all the constituents individually. It also allows investors to have a diversified portfolio, avoiding individual trading fees associated with multiple trades.
The S&P 500 has been doing exceptionally well since the pandemic, registering a 52-week and all-time high of 6,025.42 yesterday, November 26, 2024, and closed at 6,021.63. Investors are still celebrating the extended bull market, and Barchart’s technical opinion predicts a “continuation of the trend” in the long term. This presents a perfect opportunity to sell puts.
Now, for the naked put itself. Let’s take the top example from the results, which suggests selling a put with a $586 strike price, expiring December 31, 2024. If you do, you’ll receive a $3.37 premium or $337 total per option for that trade.
The trade has a 0.24 delta, which suggests a 76% chance of expiring out of the money. The OTM Probability filter pegs the chance at 73%. (As you can see here, these filters are calculated differently but point in the same direction.)
That means if you decide to keep your option until expiration, there’s an excellent chance it will stay out of the money, and you’ll keep all the premium.
But what if it doesn’t?
Mitigating Risk
It’s good practice to close all short options before expiration to avoid assignment. But I get it—life happens. Sometimes, you fully intended to close the trade on the morning of expiration, but things got in the way, and you got assigned.
To avoid such issues, investors can set up a GTC (Good-Until-Cancelled) stop loss at around 50% of the option premium. This way, should the stock trade around the strike price before expiration, the investor can “Buy-to-close” their trade to prevent buying the stock should it trade less than the strike price.
On the other hand, investors can also issue a take-profit order of around 70-80% of the premium.
If your brokerage supports a take profit and stop loss order on options pairs, the orders will work in the background to help keep as many “chips on the table” as possible.
Alternatively, if the trade moves in the wrong direction, the investor can “roll” the option by buying it back at its current price and then sell another on the same underlying at a lower strike and with a longer expiration date. However, the premiums will differ by then and can cut into your bottom line, so consider your situation carefully.
Final Thoughts
Selling puts can be an excellent way to earn a premium, hoping the underlying stays above the strike at expiration. However, if it doesn’t and your preferred stock drops below the strike price, you’ll be purchasing 100 shares at a discount. However, like with any single-legged short options, you are very vulnerable to significant downside price movements, especially if the drop far exceeds your strike price. That’s why it’s essential to sell puts only on stocks or ETFs you’d actually want to own.
And, of course, do feel free to use an option screener to increase your chances of profit, as I did today.
