Writing Naked Puts is simply selling a put option on a stock that you would be happy to own should the price come down to your desired buy price.
When we write a naked put we are effectively 'promising' to buy someone else's shares in the future should the stock price fall below a certain level.
For doing this we are instantly paid spendable cash for each share that we 'promise' to buy. If the stock does not fall below this level (the strike price), then we simply keep the cash without having to buy the stock.
Just like covered calls, only write naked puts on stocks that you would be happy to own and if you want to be more conservative, only sell the contract equivalent of the amount of shares you wish to buy, should the stock fall below the strike price.
As each option contract represents 100 shares of the underlying stock, you can work out how many contracts you can afford to write simply by dividing the amount of capital you want to invest in that trade by the strike price of the option you want to sell and then divide that number by 100.
Here's the formula:
Capital/Strike Price/100 = Number of Contracts
So if you have 20,000 to invest in one trade and let's say that the strike price of option is $10, then you can safely write 20 contracts.
By 'safely' I mean that you can afford to buy the stock should you be assigned.
Another thing to remember is that should you be assigned, you would effectively be buying your shares at a discount.
Let's say for writing the $10 put option, you received $0.50 cents per share (5% yield).
Because you receive this $0.50 per share, your overall purchase price (should you be assigned) is lowered by $0.50 to $9.50.
Should the stock fall and you be forced to buy it, a great way to keep this cash flowing and at the same time continue to reduce your risk is to simply turn around and start writing covered calls on it.
That being said, it's never a good idea in my opinion to write naked puts on a falling stock. Always look at a stock's chart for:
1) Moderate uptrends.
2) Sideways trends, especially 1-2 months AFTER a steep sell off.
If you go to: http://www.stockcharts.com and pull up the QQQQ chart for the first quarter of 2003, you'll find a great example of this second pattern.
During this time I began writing naked puts on the QQQQ and then when I was eventually assigned I then wrote covered calls on the QQQQ profitably for a number of months.
In sideways or rising markets, writing naked puts to potentially aquire stock (and be paid while you wait) and then writing covered calls on the stock when and if you are exercised, may well be the ultimate strategy for generating a cashflow income from the markets.
Also, considering that a large majority of options are never exercised, much of the time you may never even be required to buy the stock.
When it comes to writing naked puts, you often get paid for a 'promise' that you don't end up having to keep. Now that's what I call leverage!
Happy option trading and investing!
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James Thomas is a successful private option trader and creator of www.option-trading-tips.blogspot.com - an informative resource full of useful option trading tips, including free video tutorials.
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