Chris Rowe

   

The strategy of selling naked puts -- which means shorting, or "Selling to Open," put options without also being short the underlying stock or owning a long put against the naked position -- actually holds a bit less risk than just buying a stock.

Naked puts reduce the cost basis of the stock (on a short-term trade). In acceptance that there is a cap on the upside potential, we exchange it for a strategy that is more likely to end up profitable than the outright stock ownership.

I was talking about this strategy with a friend of mine, Bill Jones, who asked me if there is a way to increase the potential profit-versus-loss ratio.

Here are the highlights of our discussion:

Bill -- "Chris, on one hand, I like having better odds of success because I know I can profit from naked puts if the stock trades up, sideways or even slightly lower."

(This is true because since we're essentially selling short the naked put option, we profit when the put option loses its value as a result of time passing.)

"But on the other hand, if the stock doubles in price, I will only make the amount that someone has paid me when I sell that put option, so the profit is limited. It seems like selling naked puts is actually risky when you consider the reward."

Me -- "First of all, the risk-versus-reward ratio makes sense when you consider the fact that odds of success increase. And it's not a risky strategy, but maybe it's just not exactly what you're looking for.

"Consider the fact that I just heard, from a very reliable source, that the world's largest options trader is a guy by the name of Warren Buffett. In case you've never heard of him, he's been jumping in and out of first place on the Forbes 400 richest people list for decades.

"But, he certainly isn't a speculator. He's a value investor, and not a guy who I'd consider a 'risky' player."

Bill -- "I know the margin requirement for a put spread is only about 20% (1/5) of the underlying stock position, so I can sell five times as many put options, so at least I can profit a lot more that way if the stock trades flat or up. But that opens me up to five times the downside risk! What do you suggest?"

Me -- "I suggest that you read the Tycoon Report on Tuesday and I'll write an article about 'vertical put spreads,' since I can't legally give you individualized investment advice."

Bill -- "No, seriously."

Me -- "No ... seriously."

So if you're like Bill and ready to learn the basics about the possible profits that are waiting for you as a put seller, I'll cover the basics and give you three possible options trading scenarios that you can add to your portfolio today!