Full Disclosure Finance

By Justin

Naked (uncovered ) puts are a useful way to earn some money with low risk if you intend to purchase the stock anyway and don’t need to get in immediately.

You are “naked” when you sell a put (the put guarantees you will buy X shares on contract at the strike price if exercised) without a corresponding short position in the stock.

This scenario is exposed to “risk” because if the stock drops below the strike price and the option is exercised you will be forced to buy the stock. Therefore you would have to lay out capital on a stock that has decreased in price and could be a dog.  If the company has a catastrophe you would be stuck with shares that may never recover. 

But what if you want to buy the stock anyway?  Then being forced to buy at a lower price might not be a “risk” after all.

So here’s the deal:

If you’ve found a stock you want to buy at its current price and have done all of your homework, consider selling a front month naked put at an out of the money strike price.

You will have the premium deposited into your account and you have essentially agreed to purchase the shares at the strike price if the option is exercised.

You already have the desire to buy the shares and wouldn’t mind getting them a little cheaper.

Most major Canadian discount brokers will not let you trade uncovered.  After looking around, TD Waterhouse and ETRADE are your best bets for the discount brokers.

Here is an example:

You like the proposed infrastructure spending that the US has pledged to undertake.  Steel will be a significant component of the spending and commodity prices might be poised for a rebound next year.  So you’re thinking Nucor Corp (NUE), Andrew provided an overview back when they were really booming,  which is currently trading at $39.19 with a 52 week high of around $83 and a low of $25.

The March $37.50 put has a price of $2.50. 

1)You sell 5 puts (Total Potential Purchase of 500 shares x $37.50 = $18750 if exercised) and pay associated commissions (ETRADE will be a max of $19.95 per order plus $1.75 per contract) of $28.74.

2)$1250 is deposited to your account (500 shares x $2.50)

3) Waiting game begins. Do your best not to check Yahoo Finance every 5 minutes.

4a)It is getting close to March 20 and the stock price has stayed steady around $40. The option will not be exercised and you keep your premium. 

4b)The stock drops to $35 and you are required to buy 500 shares at $37.50 on or around March 20.  Keep in mind that you have collected $2.50 per share in premiums and paid $37.50. So unless you spent the $1200 on a gold-plated iPhone, your cost basis is $35.  You have then bought the shares at market price after an 11% drop in the stock price over a month.  If you bought before the drop you are now down 11%.

5a)Repeat the next month until you get exercised and keep the premiums while you wait.

5b)Hold the stock as per your bullish take on steel and infrastructure and you have now bought Nucor for $35 when you were ready to buy at $39.19.

There’s no time like now to find some great stocks you wouldn’t mind buying for below current levels.  Consider naked puts as a way to get into those positions when Mr. Market permits and be paid to wait in the process.

Risks are present, but if you like a stock and are ready to buy at current levels, go naked and sit around for a while instead!