A Naked Kamikaze

Don't go naked. It's not that you'll catch a cold but you might have to buy stock you don't want to buy. To a stock option trader, going naked is buying or selling (writing) an option contract without owning the underlying stock. But you already knew that. And chances are you also know that most stock option traders will tell you to never sell naked puts. I say most because I have used selling naked puts successfully for years. I don't recommend it because for many traders it would indeed be the wrong thing to do. But for some, it could work out well. It did for me.

Here's my story. I used to own a medium sized company which had the advantage of having a large line of credit which we rarely used. At the time, we paid about 8% interest. As I was in charge of managing our money, I was always looking for ways to optimize our assets. One day it hit me. I have this line of credit, which I fortunately don't need, but I wondered if there was a way I could use it in a productive manner for the company. As a desk bound executive, I had the capability to trade stocks and options because a computer was always an arms length away.

I had this mysterious friend who somehow made a good living for him and his family by no obvious means. Once I broached the subject and he muttered something about stock options. I prodded him and he explained a strategy that provided him with a steady stream of income. It got my interest and I offered to pay him if he would show me how to do it. He obliged and in ten minutes, I was out the door shaking my head. He was nuts because he was defying a common taboo of selling naked puts. Soon, I became focused on the unused LOC because the bank had informed us that they wanted to close out our credit line because we weren't using it. So, I started to do some paper naked put option selling just to see if my nutty friend was right. Within a short period of time, I was pleasantly surprised. I just needed to focus on stocks that I wouldn't mind owning if I were somehow forced to cover. Then it hit me. This line of credit was like having a huge margin account. It cost me 8% per year on any balances and yet I figured that I could fairly regularly make 5%-7% on out-of-the-money naked put options on stocks I wouldn't mind owning if I had to.

The way I do it is the following: I look for out-of-the-money put options that have a time value that if divided by the stock price would yield at least 5%. For example, let's say a stock has a current price of $40 and has an out-of-the-money put option with a strike price of $38 for a premium of $2. The time premium is $2 so if we divide the time premium by the strike price, we get a return of 5.6% exclusive of the costs of the round trip commission. All that is needed is for the stock to stay neutral or move up until the option month expires. If you do that repeatedly, you can have some nice annualized returns. The key is to have the cash to cover the purchase of the stock if required to do so.

So, I decided to tap my company's credit line for about 20% for trading activities. "Getting naked" became part of my everyday routine and low and behold after the first year I had managed to capture a total return of over 35% net all transaction costs. I was forced to cover only three times in the year. Within several months, I was able to recoup the LOC cost by liquidating the stocks once they reached breakeven. Over the past six years, I have accumulated almost as much money by going naked in my office as we make from one of our smaller divisions.

It might not be a good thing to do, but I, for one, don't hold to selling naked puts as something bad. Just be sure you have a big wardrobe in the closet if you need it.