Selling Naked Puts: Getting Paid to Place Limit Orders On Your Favorite Stocks
by Lee Lowell, Stock and Commodity Option Specialist
Tuesday, February 15, 2005: Issue #184
Did you know you could have someone pay you cash today while you place a limit order on your favorite stock? It’s true. Just for your effort of placing a limit order on a stock below its current price, someone will give you cold, hard cash.
When you want to buy a stock at a lower price, what do you do? Most people would put in a limit order below the stock’s current price and hope and pray the market sells off. I’ll show you a way to use your money more efficiently while you wait for the market to come down.
I’m going to show you a method of using a certain kind of limit order through an option strategy called “naked put selling.” Which is a slightly different strategy than from what most people would use.
Why You Shouldn’t Worry About Selling Naked Puts
Now don’t get worried about seeing two of the more aggressive option terms in the selling naked puts strategy – “naked” and “selling”. If you’ve ever traded options before, you know that selling naked options entails unlimited risks. But with naked put selling, the risk is for a good cause – buying your favorite stock at a lower price.
I must emphasize this next point very strongly. You MUST only sell naked puts on stocks that you DEFINITELY want to buy and keep in your portfolio.
If you sell naked puts just to receive the premium and don’t have any intentions of owning the stock, then this article is not for you. Selling puts just to receive the premium income is a speculative play and more of the gambler’s type of trade. We don’t want that with this strategy.
Limit Orders … This Isn’t Mickey Mouse
Okay, so how do we do it? Let’s take Disney (NYSE: DIS) for example. It has been in a nice uptrend and also hitting close to four-year highs, around $29. You’d like to get in and buy some but don’t want to buy at its current high price, as you feel a pullback is due to happen.
You think DIS may retrace to its 50-day moving average, which is currently around $25. You also think this may happen within the next two months.
At this point, you could be like many other investors and just put in a limit order to buy the stock at $25 and wait to see if you ever get filled.
Or, you can look at DIS put options and see what they are trading for. As of Feb. 3, 2005, the DIS April ’05 $25 puts had a closing bid of $0.15. If you sell puts, two things happen:
- You will get paid.
- And, just as with a limit order, if the stock falls below $25, whoever buys the puts will exercise. And you’ll get what you wanted… Disney stock at $25.
When you sell puts, for every contract you sell, you will get $15 deposited into your account. (There are 100 shares per contract, so $0.15 x 100 = $15.) You wouldn’t get that money if you put in a straight limit order on the stock.
What We Want Put Options To Do For Us
Now, if you’ve ever sold put options before, the only way you will get assigned on the option is if the underlying security trades below the strike price at expiration. That’s what we’re hoping for in this case. We want DIS to trade down to $25 so that we get assigned and have 100 shares of DIS deposited into our account.
So how is this better than just putting in a limit order and waiting for DIS to trade down to $25?
Well, for starters, since we sold the put option for $0.15, we’re effectively lowering our cost basis to $24.85 per share, whereas the straight stock buyer has to pay $25 per share.
Also, we’re getting paid $15 up front for our efforts, which goes into our account, which will earn interest along with the rest of our available funds. But that’s if you’re right the first time… it can get even better.
If You Lose, You’re Still Making Money with Naked Puts
Now, if DIS never trades down to $25 by expiration, what happens? Well, the put buyers won’t exercise, and you won’t get to buy the shares for $25. But you will keep the $15 you were paid for the opportunity.
And then you can do it again. You can sell puts for the next expiration and see if you get assigned the shares. If you never get to buy DIS you have consolation knowing that at least you’re bringing in cash flow, which helps the return on your available funds, whereas the straight stock buyer is just earning the paltry 1% interest paid by most brokerages (if they pay at all) with no extra $15.
If you’re in the market to buy stock, don’t let anyone tell you that selling naked puts is riskier than owning stock.
After all, what’s your risk when buying stock? Your risk is that the stock falls to zero. What’s your risk with selling naked puts if you get assigned the shares? Your risk is that the stock falls to zero.
It’s exactly the same risk as owning stock outright… But with naked put selling, your cost basis is lower because of the premium you receive upfront.
So the next time you’re looking to buy some stock below its current price, think about selling some put options.