Chris Rowe

   

BACK TO BILL

Remember, Bill said that he could increase his reward tremendously, but he also brought up the excellent point that he would then be increasing his risk.

What he is saying is that, using our OIH example, the margin requirement is $3,260 with a $700 upside. And, he's acknowledging that instead of buying 100 shares of OIH, which requires $17,000 (or $8,500 on margin), or selling the naked puts, which requires $3,260, he can take about $16,300 and sell five times as many put options, which will bring in $3,500 in premium ($700 x 5).

At the same time, he realizes even though his breakeven point is still $163, he would be losing $500 (instead of $100) for every point that the stock traded below $163.

His concern here is if the stock or ETF on which he sold naked puts trades down by a large amount (e.g., if it lost 50% in a day), he would lose five times more than he would have lost past his breakeven point. But, he likes the concept of the high-probability bet, so he's tempted to use the high leverage.

MY ANSWER FOR HIM

I know you like the concept of profiting from time decay -- i.e., the deterioration of the option price due to time passing -- of the option that you sold. If your focus is to profit from a security by staying above your breakeven point with either little or no downside movement (as opposed to your focus being on trying to actually buying the stock), then you should try selling vertical put spreads.

GOING VERTICAL

With a vertical put spread, you are basically doing the same thing that you would do with a naked put, except you're also buying insurance on the position by purchasing another put with a lower strike price. The margin requirement is the difference between the two strike prices.

So, let's go back to our OIH example using March 170 Put options.

When we enter a spread, or a two-sided trade, we enter both "legs" of the trade at the same time (which is technically entering two trades simultaneously).

Here are three examples, because there are a few different ways to profit.

Dawn Pennington

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