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Uncovered Options
The Smart Profits Report: Issue #271
Tuesday, January 3, 2006
Uncovered Options: A Win-Win Trade that “Puts” You In the “Bookie’s” Seat
By Jim Stanton
Advisory Panelist, Mt. Vernon Research
The world of options trading has undergone some major changes in the last decade. Consider these two:
- First, the volume on the Chicago Board of Options Exchange has increased by more than 50% since 1998. This fact alone has produced better price efficiency (tighter spreads), which in turn, has attracted more players.
- Second, not only are there more players, there are better tools for them to use - the biggest and most improved, of course, is the computer. It’s given traders an entirely new set of ways to implement options strategies. There are so many different strategies that, at times, it can make your head spin.
So, how do we know which strategy to use? Well, it’s not enough to pick the right strategy. The key is using the right strategy at the right time. Let’s look at one of my favorite combinations of these two elements, namely uncovered options also called naked options…
The Right Strategy at the Right Time
The outright buying of puts or calls gives you the most leverage, but there are times when selling uncovered options (naked) makes more sense.
I have always been a fan of selling options instead of buying them, for a couple of reasons. As the seller, you collect the time premium instead of paying it, and if the underlying stock goes into a holding pattern, you can still make money on the trade.
In short, you are now booking the bet instead of making the bet… and we all know who consistently makes money in the long run.
Since getting my broker’s license in the early 1980s, I have seen and/or used options for just about any scenario you can imagine. But late summer is the time of year that I implement one of my favorite strategies.
Get a Discount On Your Long Stock… And Get Paid Along the Way
Historically, the stock market enjoys a summertime rally, which, in most cases is followed by a period of weakness that usually ends in the September-October time frame.
This strategy requires the intermediate-term outlook for the market to be neutral to bullish and that you use this (or any other) historically weak period to add to your long positions. Once these conditions are met, the next step is to choose which stock or stocks you would like to buy and the price at which you would be willing to purchase them.
You then sell an out-of-the-money put, with the intention of having the stock “put” to you (buying the stock) below the current market value at a price at which you are willing to pay.
Uncovered Options In A Summertime Rally
For this example, I will use the current stock and option prices for Genentech (NYSE: DNA), but we’ll assume that it’s mid-to-late August - a good time for a summertime rally to run out of steam.
DNA recently traded at $94, but you wouldn’t want to pay more than $88. The $90 put options that expire two months from now were recently trading around $3. You could short those options for a $3 credit, and if the stock falls below $90, and the option is exercised, your net cost is $87 per share. ($90 cost minus the $3 credit).
Since you wanted to own the stock at $88 or better, you got your wish. If the stock does not trade below $90, you would not have been filled at your price anyway, and the $3 premium is yours to keep. As a safeguard against an unexpected market meltdown, I always use a safety stop on the stock once the uncovered option trade is executed.
You can implement these trades in any corrective move within a bull market. It’s a win-win situation… and who doesn’t like those kinds of odds?
Good Trading,
Jim
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Today’s Smart Profits Cribsheet
- Speaking of options strategies, take a look back at Smart Profits #175, Limit Prices: Tip the Odds on Options Trades In Your Favor. Karim talks about how important it is to use limit orders with all of your options trades.
- Visit our free Smart Profits Glossary for definitions of words like “leverage,” “uncovered options” or “market order” found in today’s article.
Related Articles:
- Out of the Money Options: Buyer Beware, Seller… Take The Money
- Selling Covered Calls: Getting Cash for Stocks You Already Own
- Option Credit Spreads: Sell First, Buy Second for 50% Better Odds
