The Great Naked Put Misconception and Gap Risk

Published on: Mar 13 2013 by John Critchley

 

By: John Critchley

 

If you turn on CNBC, you will see the option talking heads like Dr. J or other self proclaimed option experts extolling the virtues of naked put selling.  The mantra goes something like this:  Sell some downside puts and in the worst you will just own the stock at the strike price minus the premium.

What they don’t tell you about is something called Gap Risk.

What is Gap risk?

The retail customer heard this all the time last fall from the mainstream business media. “ AAPL is $508 and you can sell the Jan 490 puts at $10. Worst case you own it $480”  Sounded good, no? Hold on.  When AAPL was $508 before earnings, you could have sold the Jan 490 puts at $10. True.  But what happened when $AAPL bad earnings and the stock opened at 450.  You owned the stock at $480, not $450. Doesn’t sound so great now- does it? Gap Risk.

AAPL is now $433.  Well done talking heads, another service well provided to the public.
To be fair-  Example of when this strategy can work:

IBM stock is trading $212.

Objective: You like IBM stock, but you think it is a little too expensive and would like to buy it after a 5% pullback.

Possible strategy: Sell three month  IBM July 200 strike put at @ $4.00

 

AT EXPIRATION
If the stock is above the 200 strike price, the Put expires worthless and you keep the $4.00.
If the stock is below the 200 strike price, the Put will be assigned and you would have an obligation to buy 100 shares at $200/share.
Your effective stock purchase price would be $196.

$200 – $4.00 Put Premium = $196

Break-even-IBM at $196.

Risk- Stock ownership below $196.

IN SUMMARY: Selling Puts is way to purchase stock on a pullback, but beware of gap risk. This strategy works well if there isn’t a big gap down in IBM before July expiration.

 

Key point: remember-  90% of large outsized downside moves are ‘gaps’ down.  Try this test- Look at the daily biggest % minus movers and then look at the opening price of these stocks. The majority of the time these stocks gapped down. It is quite rare for a stock to open unchanged and then crater 5 or 10% intraday. It happens but it is quite unusual. Companies are very aware that market moving news is best left to pre or post market.  Also normally not on expiration Friday’s.  The exceptions are macro events or events out of the control of a company. FDA ruling, court ruling etc. 

 

Oh, by the way there will only ever be one real Dr. J.   

Julius Winfiled Erving II

Position: Forward-Guard ▪ Shoots: Right
Height: 6-6 ▪ Weight: 200 lbs.
Hall of Fame: Inducted as Player in 1993

 

Stay tuned………

 

Notes: Prices quoted where the prices at time of submission and do not reflect current market

 

Disclaimer


We are not liable for any trading decisions made by any reader. NO advice is given or implied. The information offered in  this article is for demonstration purposes ONLY and should not to be either construed as an offer or considered to be a recommendation to buy or sell any options .

Your use of this information is entirely at your own risk. It is your sole responsibility to evaluate the accuracy, completeness and usefulness of the information. You must assess the risk of any trade with a professional broker, or financial planner, and make your own independent decisions regarding any trades mentioned herein. This is not a solicitation to buy or sell any options, or to purchase or sell any credit spreads. Trading options only carries a high degree of risk, is not suitable for all traders/investors, and you may lose all of your premium money invested in the options. If you have never traded options before, we strongly recommend that you read a little background information made available by the government. Only you can determine what level of risk is appropriate for you. Also, prior to buying or selling an option, a person must receive a copy of Characteristics and Risks of Standardized Options.

Past performances DO NOT guarantee future results. Please consult with your own independent tax, business and financial advisors with respect to any trade. We will NOT be responsible for the consequences of anyone acting on this purely demonstration material.

 

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One Comment to “The Great Naked Put Misconception and Gap Risk”

  1. John Olagues says:

    Your article makes good sense., although the out of the money puts are generally overpriced as many “zero cost collar” buyers force them up.

    John

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