Trading short naked puts (i.e., put selling or put writing) can be an effective and profitable options trading strategy. The attraction of naked put selling is often the ability to collect premium with a margin for error if the stock drops while having the ability to purchase stock at a discount to the current market price. The trouble comes, however, when the stock moves lower and challenges the naked put position. Today’s show is dedicated to helping you understand all the ways you can hedge short naked puts.
This episode is specifically geared towards those people who like to trade short puts, and, as you will see, there’s more than one way to approach this task. Whether it’s put selling or put writing, we’ll talk through the different ways in which you can hedge and adjust and roll those contracts. If this is something that’s in your wheelhouse, you’ll definitely enjoy today’s podcast.
We will be looking at six different ways to hedge or adjust these puts and highlight the risks associated with a leveraged position like this, particularly during black swan events.
It doesn’t matter if you do all of them, or just one, find a method or combination that works for you.
Understanding the Risks of Naked Puts:
- As long as the stock stays above our breakeven point, we have an opportunity to make money on this trade. You can then carry on with this strategy the next week, month, or next quarter, as you see fit.
- Naked puts generally work out really well when markets are either moving up, moving sideways, or even in a little bit of a downtrend. The problem arises when markets crash or if you start selling put options when implied volatility is really low.
- That does not mean you should avoid trading this strategy. Merely, that you should understand what to do when those types of situations occur. To put it simply, naked puts work well until they don’t!
First Hedging Method — Buying a Put at a Lower Strike:
- When you buy a put at a lower strike, this creates a put credit spread and is a great way to hedge as you can control margin and risk. It is worth it to trade these short naked puts in a synthetic spread version, as it gives you defined risk.
- It is worth spending some money to buy tail protection, as it can come in handy, especially in times like the major black swan from earlier in 2020. This protection can save you when another one of these events comes around.
- In different stocks and ETFs in different circumstances, that protection pricing might be far out at a lower strike, or it might be close, whatever the case is.
Second Hedging Method — Selling a Short Naked Call Option and Converting It into a Strangle:
- This is a little more complex than the first method, and it means we need to start talking about the stock movement. It is a very classic way to do hedge, and it depends on when you want to do hedge and how wide your position is.
- There’s a lot of factors that go into this method. A good way that you can hedge a short naked put option is to sell an opposing set, or series, of call options on those short puts that you sold.
- When you start converting a position over and you sell the naked short call and convert it into a strangle, you’re confining your profit zone to inside the breakeven points.
- This can be comfortable or not for you, depending on the underlying stock’s movement. The tradeoff here is that you have a wider breakeven point on the put side, so it gives you more room to be wrong in case the stock continues to move down.
- In exchange, you had to give up some of the upside window of profit on the position. For the most part, it’s not going to cost you a lot of margin to do this because you already have a lot of margin tied up in the short put option contract.
- Make sure to check with your broker and then test this out for yourself. Maybe do some paper trading around it and see how it works with your margins.
Third Hedging Method — Executing a Collar on an Existing Position:
- The execution of a collar is a great strategy to use on top of existing stock positions and is a highly effective way to hedge.
- Usually, people try to do this for a net-zero cost, or even just a small credit or very small debit, to reduce the cost of insurance. You can sell a call option, which reduces the upside potential, and then use that premium that is collected from selling the call option to buy a put option at a lower strike.
- If you’re selling a naked put option, that still keeps all of the downside risk. With this hedge, you’re using that premium to buy, or finance, most of the purchase of an additional long put option contract.
- The trade-off here is you don’t have as wide of a breakeven point or any wider breakeven points than you initially had. If you’re really concerned about the stock taking a nosedive, this might be a good alternative.
Fourth Hedging Method — Hedging with Short Futures:
- Now we are moving into the advanced strategies! Hedging with short futures allows you to start thinking creatively about how you can hedge positions and, in some cases, with different products.
- You can use this as a tool to start thinking of different ways you can use other products. If you’re trading short puts, you might have a bunch of short puts on tech stocks, and you could use QQQ as a means to hedge that position and start to execute some of the other strategies.
Fifth Hedging Method — Rolling Down Your Short Call Positions:
- The fifth way piggybacks off the second (selling a short naked call). It allows you to continue to hedge a position by rolling down your short call option contract and continuing to move it closer to where the stock is trading.
- There’s no perfect formula for this, but the general idea is to collect additional premium.
- This method’s trade-off is that when you continue to move down your short call strikes, you’re compressing and shrinking the possible range in which the stock can move and the position remain profitable as it heads towards expiration.
Sixth Hedging Method — Rolling Out The Position for Extra Duration and Credit:
- The last option we are exploring today is the next logical step. It would be the last thing that we do if the other strategies do not work, and we find ourselves at the expiration.
- When we roll a contract, or a series of contracts, out to the next month to extend the duration, the goal is to punt the position for an extended period, whether it is a month or longer. But, only if we can collect a premium and an additional credit for extending that timeline.
- We need to avoid risky behavior while doing this as we do not want to dig ourselves into a deeper hole.
- When we talk about rolling out the position, all we’re talking about doing is simply closing the current month’s contract you’re trading right now. You buy back those contracts, and you reopen the exact same contracts in the next month. This effectively increases the premium collected in the position in the totality of the trade, making it a good hedging method.
Option Trader Q&A w/ Nico
Trader Q&A is our favorite segment of the show because we get to hear from one of our community members and help answer their questions live on the air. Today’s question comes from Nico:
Hello, Kirk. I hope you’re well and I hope your family is well during this pandemic. I have three quick questions. It won’t take much of your time. My first question is regarding rolling a position to the next expiration period, versus adjusting it. Let’s say for example, that you have a credit put spread at 30% probability of it being in the money and you have 30 days until expiration. Now, let’s say two weeks – let’s say three weeks pass and now you have two weeks until expiration and the stock went completely against your directional assumption, so you’re at a loss right now. Now, would you cut your losses more if you roll it to the next expiration period, or adjust it by making an iron condor? That’s my first question.
My second question is regarding commissions. Now, I don’t know about you, but in my situation, they charge me $6.50 per contract. This is an absurd amount of money, given if you have a very limited amount of money to invest in. Yeah, that’s that. My question really is, what other platform do you prefer, or maybe that you use that would allow me to go around these commissions, or pay less amount of commission? That’s really my question.
My third question is I’ve been trading options, so basically for 60 days now and it’s been going really well. I started with $2,000 to play around with and now I’m at $6,000. It hasn’t really been consistent. I’ve been losing here and there and then I’ve been gaining. But when I’ve been gaining, I’ve been liquidating it. What I’ve been doing is I’ve been reading the news. I’ve been doing technical analysis as well and I’ve been really buying calls and puts at the money, buying calls or puts at the money and far out of expiration, so almost a year off expiration period. Do you think this is just luck? Should I keep doing it? Should I avoid it? What are your thoughts about it? That’s about it. Thank you very much.
Remember, if you’d like to get your question answered here on the podcast or LIVE on Facebook & Periscope, head over to OptionAlpha.com/ASK and click the big red record button in the middle of the screen and leave me a private voicemail. There’s no software to download or install and it’s incredibly easy.
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About The Author
Kirk founded Option Alpha in early 2007 and currently serves as the Head Trader. In 2018, Option Alpha hit the Inc. 500 list at #215 as one of the fastest growing private companies in the US. Formerly an Investment Banker in the Mergers and Acquisitions Group for Deutsche Bank in New York and REIT Analyst for BB&T Capital Markets in Washington D.C., he’s a Full-time Options Trader and Real Estate Investor.
He’s been interviewed on dozens of investing websites/podcasts and he’s been seen in Barron’s Magazine, SmartMoney, and various other financial publications. Kirk currently lives in Pennsylvania (USA) with his beautiful wife and three children.