Short Naked Puts

Another trader, Stacie, has also been studying Johnson & Johnson. Stacie believes Johnson & Johnson is on its way to test the $65 resistance level yet again. She believes it may even break through $65 this time, based on strong fundamentals. Stacie decides to sell naked puts. A naked put is a short put that is not sold in conjunction with stock or another option.With the stock around $64, themarket for theNovember 65 put is 1.75 bid at 1.80.

Stacie likes the fact that the 65 puts are slightly in-the-money (ITM) and thus have a higher delta. If her price rise comes sooner than expected, the high delta may allow her to take a profit early. Stacie sells 10 puts at 1.75.In the best-case scenario, Stacie retains the entire 1.75. For that to happen, she will need to hold this position until expiration and the stock will have to rise to be trading above the 65 strike.

Logically, Stacie will want to do an at-expiration analysis. Exhibit 5.4 shows Stacie’s naked put trade if she holds it until expiration.While harvesting the entire premium as a profit sounds attractive, if Stacie can take the bulk of her profit early, she’ll be happy to close the position and eliminate her risk—nobody ever went broke taking a profit.Furthermore, she realizes that her outlook may be wrong: Johnson & Johnson may decline.

She may have to close the position early—maybe for a profit, maybe for a loss. Stacie also needs to study her greeks. Exhibit 5.5 shows the greeks for this trade.Stacie’s trade is not just a bullish version of Brendan’s. Partly because of the size of the delta, it’s different—specific directional bias aside. First, she will handle her trade differently if it is profitable.

For example, if over the next week or so Johnson & Johnson rises $1,positive delta and negative gamma will have a net favorable effect on Stacie’s profitability. Theta is small in comparison and won’t have too much of an effect. Delta/gamma will account for a decrease in the put’s theoretical value of about $0.73. That’s the estimated average delta times the stock move, or[0.65 1 (0.15/2)] 3 1.00.

Stacie’s actual profit would likely be less than 0.73 because of the bid-ask spread. Stacie must account for the fact that the bid-ask is 0.05 wide (1.751.80). Because Stacie would buy to close this position, she should consider the 0.73 price change relative to the 1.80 offer, not the 1.75 trade price—that is, she factors in a nickel of slippage. Thus, she calculates, that the puts will be offered at 1.07 (that’s 1.80 2 0.73) when the stock is at $65.

That is a gain of $0.68.In this scenario, Stacie should consider the Would I Do It Now? rule to guide her decision as to whether to take her profit early or hold the position until expiration. Is she happy being short ten 65 puts at 1.07with Johnson&Johnson at $65? The premiumis lower now. The anticipated move has already occurred,and she still has 28 days left in the option that could allow for the move to reverse itself.

If she didn’t have the trade on now, would she sell ten 65 puts at 1.07 with Johnson& Johnson at $65? Based on her original intention, unless she believes strongly now that a breakout through $65 with follow-through momentum is about to take place, she will likely take the money and run.Stacie also must handle this trade differently from Brendan in the event that the trade is a loser. Her trade has a higher delta.

An adverse move in the underlying would affect Stacie’s trade more than it would Brendan’s.If Johnson & Johnson declines, she must be conscious in advance of where she will cover.Stacie considers both how much she is willing to lose and what potential stock-price action will cause her to change her forecast. She consults a stock chart of Johnson & Johnson. In this example, we’ll assume there is some resistance developing around $64 in the short term.

If this resistance level holds, the trade becomes less attractive. The at-expiration breakeven is $63.25, so the trade can still be a winner if Johnson & Johnson retreats. But Stacie is looking for the stock to approach $65. She will no longer like the risk/reward of this trade if it looks like that price rise won’t occur. She makes the decision that if

Johnson & Johnson bounces off the $64 level over the next couple weeks, she will exit the position for fear that her outlook is wrong. If Johnson & Johnson drifts above $64, however, she will ride the trade out.In this example, Stacie is willing to lose 1.00 per contract.

Without taking into account theta or vega, that 1.00 loss in the option should occur at a stock price of about $63.28. Theta is somewhat relevant here. It helps Stacie’s potential for profit as time passes. As time passes and as the stock rises, so will theta, helping her even more. If the stock moves lower (against her) theta helps ease the pain somewhat, but the further in-the-money the put, the lower the theta.