When to get naked

October 27, 2015 09:00 AM

Everyone has heard that writing naked or uncovered options is extremely high risk. But the risk is no different than an outright position and there are times when it is appropriate. 
Consider the case of Costco (COST) during the August market correction. On the big drop of Aug. 24, Costco gave off bullish signals in spite of the  larger market-wide price decline. 

First, price dropped below support at $137 with a gap from the previous day’s trading range indicating a reversal would occur and price would move back into range. It looked like the Costco breakout was part of the overall market decline that day. Second, the big 15-point lower shadow revealed bullish strength. The stock price rose slightly on the big day. Third, relative strength index (RSI) revealed oversold conditions on Aug. 24 for the first time in several months. And fourth, volume spiked on Aug. 24, further confirming interest in the stock (see “Buying Costco”). 

Price moved back above support by Wednesday and remained there through Friday. So, with all of this, what option moves could you have made on Aug. 24?

Ownership of the stock would eliminate a covered call as an option since the signals predicted a bullish reaction. So the uncovered put would have made more sense at any strike below 130. On Aug. 25, the strength of Costco was more obvious as the stock price held and closed at the same price as the previous session’s close. At this point, selling a 135 put would have been justified. Price was approaching previous support; volatility settled down; and momentum was back in range.

Calls vs. puts

In comparing the covered call to the uncovered put, keep in mind the following guidelines: The net cost (strike-premium) must be a reasonable price for the stock; you must be willing to have 100 shares put to you at the strike, even with market value below that strike; to avoid exercise, you are prepared to roll forward or forward and down; and you can enter into a “recovery strategy” after exercise. At that point, you may write covered calls to improve your basis. Just be sure that if the covered call is exercised you come out profitably on the other end. 

Why compare uncovered puts to covered calls? Because the market risk is identical, but with some notable qualifiers:

  • Exercise of a covered call means stock is called away and the position closes; but exercise of an uncovered put means you have to buy 100 shares at the strike, which will be higher than market value.
  • Stock earns a dividend, so a covered call has to include a calculation of this additional income.
  • If the stock rises, the covered call will be exercised (unless you close or roll). But the uncovered put expires worthless.
  • You cannot roll a covered call to a position below your net basis in stock or exercise will result in a net loss. With an uncovered put, you can close and replace without concern for exercise at the strike resulting in a capital loss. If you generate net profits, the uncovered put has much greater flexibility.
  • Stock can be bought on 50% margin, but the uncovered put requires 100% of the strike. 
  • You tie up more capital with an uncovered put.

The range of potential uses of options is broad, as is the risk level. As you consider possible strategies, whether for swing trading, pure speculation or as part of a broader portfolio plan, take another look at the naked put. It might not be as bad as you think.

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