You have probably heard or read that selling (writing) uncovered puts, also known as naked puts, is extremely risky.
This is actually true, but only part of the story. The whole truth is — all market investing has risk!
As with any investment strategy, there are trade-offs along with downside consequences. As a whole, selling naked puts have more upside benefits than down.
In researching naked puts, you will see that your upside is capped, and your downside is unlimited. Unlimited, as in without limit? Is that even possible?
No, it’s not, because there is no such thing in nature or in the markets as unlimited. We live in a finite world and invest in finite markets.
So what are they saying? The truth is that your upside is capped to the amount of your premium. By receiving payment upfront is one of the best reasons to sell naked puts.
Your downside can be significant, but it’s definitely not unlimited!
For example, if you sold a naked put for a stock that is $50 then your maximum downside is $5000 (minus the premium you received). Like an insurance policy that would be what you would owe the buyer of the put in the event the stock goes to zero.
Their stock is worthless, so their insurance will pay for the loss, which is you as the policy writer. The shares will be put to you, which you pay the agreed-upon $50 per share times 100 shares.
However, part of this agreement is that it has to happen within a certain time period. If the “insurance” is for 30 days and on day 31 the stock drops to zero, then you as the writer don’t have to pay anything — the policy has expired.
A stock can fall significantly in a month, but it is extremely rare for it to go all the way to zero in that timeframe.
Even if you sold a put on a stock that rapidly fell, you should never be in the position to pay out the entire amount. Based on your trading plan, you will roll to another month or you can buy-to-close (BTC) your position and cancel the contract to minimize losses.
The theta (time) decay is especially important because as time deteriorates out of the premium the price decreases. And it’s not linear.
Starting at 45 days-to-expiration (DTE) the decay increases taking more value out of the premium. This is why put sellers particularly prefer stocks that go sideways. You are positive theta, taking advantage of the premium price decline without necessarily a decline in the stock.
Why short puts beat long calls
Watching videos or reading blogs you will quite often be steered toward buying calls. They have a similar function as selling puts by profiting when the stock goes up.
Your loss is capped, and your profit potential is unlimited.
Again, you can’t have limitless profit, but it can be substantial when you get a large increase during a run up on a stock. Like the stock going to zero, this is not common, and extremely hard to predict when and where it will happen.
Additionally, you don’t benefit when the stock goes sideways. The premium will decrease, again because of theta, if the underlying price doesn’t move much.
Your only possibility of profit will be if the stock goes up. You either exercise your option to purchase the stock at a lower price than it was when you bought the call or you sell-to-close (STC) and take the profits by canceling the contract.
With call-buying, you are only able to profit one out of three possibilities and you are negative theta. Put-selling benefits you two out of three possibilities, increasing your chance of profit.