posted on 29 October 2015
by Russ Allen, Online Trading Academy Instructor
Well, the title is a little bit of false advertsing because the puts are not truly naked - they are backed with cash. Cash-secured put sales is an option strategy used by many smart investors as a way to buy stock cheap.
Here is how it works. Let's say you would like to buy a certain stock or exchange-traded fund as a longer-term investment. The stock has been in an uptrend. You have been placing orders to buy on pullbacks, but the pullbacks haven't been deep enough to trigger your orders. Your money is tied up by the orders, yet you still don't have the stock. What to do?
Here is an example. Look at the following chart of GLD, the exchange-traded fund that tracks the price of gold (1/10 ounce of gold per share of stock):
Since August, it has been heading up, making higher highs and higher lows. You believe (let's say) that it would be a good buy at $110 per share.
If you place a good-til-cancelled order now to buy at a limit price of $110, then when and if GLD drops to that price your order will be filled. That could happen tomorrow, next month or maybe never. Meanwhile, as long as such an order was in place, funds would have to be reserved in your account for the purchase. For one hundred shares, that would amount to 100 X $110 = $11,000.
An alternative would be to sell a put option at the $110 strike price. This would tie up the same amount of money, but there are two important differences:
On October 21, GLD puts at the $110 strike price, with an expiration date of November 20, could be sold for $1.12 per share ($112 per 100-share contract). By selling one of those puts you would legally obligate yourself to buy the 100 shares of GLD at $110 if asked to, no matter what the market price of the shares might be. The $11,000 cash in your brokerage account would be the security for that obligation.
The obligation would cease to exist on the option expiration date, November 20. After that time, if the option had not been exercised, the original $11,000 would be yours again to do with as you please, along with the $112 that you had received for the puts. That $112 amounts to a little over 1% of the $11,000 investment, in one month. That is a rate of return of over 12% a year - if the options are not exercised.
If the price of GLD should drop below $110 and remain there at the November expiration, then whoever had purchased the option would find it worthwhile to exercise it. In that case, you would receive the shares of GLD. The $11,000 in cash that had been reserved would be removed from your account. Factoring in the $112 that you earlier received for the put sale, your net cost of the GLD shares would be $11,000 less $112, or $10,888 for the hundred shares, $108.88 per share.
This could be a good thing or a bad thing depending on exactly where the price of GLD is at the time. If it is above $108.88, then it is a good thing. If it is below, then you would have a loss overall. Worst case would occur in the case of a very large drop in GLD, far below $108.88, in which case your loss could be large.
Even so, your loss on this trade would be less in any case than it would have been had you simply bought the GLD shares at $110. Your cost is less than that by the $1.12 per share put premium received.
Cash-secured put sales are an effective way to build a portfolio at discounted prices. There is much more to learning money-making option techniques for investors. To learn more, contact your local Online Trading Academy center about our ProActive Investor Program.
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