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One of my most consistently profitable strategies at

OptionsProfits

has been the naked, or "cash-secured" short put. I have done more than two dozen of them during my time here. Our own Dr. Paul Price is also fond of the strategy, and I have learned a few good twists from him in the past few months. You can see a good summary of his recent trades

here

; his trading ideas are always must-read affairs.

Given our attraction to this strategy and the fact both Dr. Price and I will probably keep up the pace of delivering new short put ideas here, I thought it would be good to review the basic goals, mechanics, and risk/reward outcomes of selling puts. This discussion won't be exhaustive, of course, but I will cover most of the basic issues. Consider this one source of knowledge among three other vital ones: your broker, and the OIC and CBOE websites.

Selling Volatility, Buying Stock 'At a Discount'

Whenever I recommend a short put strategy, I always remind people that they are taking on the risk of having to buy the underlying shares. Therefore, you have to like the stock enough to buy it, and you have to hold a good portion of the cash required in your account to "secure" or collateralize the position. Selling puts isn't just about collecting premium you hope to keep most or all of. It's about strategically creating a buy point for the stock at a predetermined price. Ideally, you may be able to sell a two- to four-month put 5%-10% below the stock price for 5%-10% of the value of the strike, depending on volatility. Here's a recent trade example:

On Feb. 9

I sold

Suncor

(SU) - Get Free Report

June 38 puts at $2.00 with the stock trading just above $40. I liked the stock and I would be happy to buy it at $38. Plus, I was getting paid $2 just for taking that risk. That lowered my effective buy price for the shares to $36 if assigned. How would I be assigned and forced to buy the stock? If the stock price fell below the strike price any time before expiration, any long holder of the June 38 put could exercise his right to be short stock and I could be randomly assigned by the OCC. At expiration, if no long holder has voluntarily exercised, I will be automatically assigned on any short options that are $0.01 or more in-the-money.

Knowing the Risks

When assigned, my broker must take cash in my account and apply it to the purchase of the underlying shares. That means your broker is always holding you accountable for this risk of assignment. If the put is completely "cash-secured," your broker will use as margin the amount of cash required to buy the shares, which means you can't use that cash for any other positions. If you have a more liberal arrangement with your broker, you may be allowed to post 20% margin (of the strike price), plus whatever amount the option is in-the-money, less the initial credit received. Obviously, this margin requirement can escalate the farther the underlying security slips below the strike of the short put. These are good questions to ask your broker before you find yourself in this situation.

There are other factors and risks to consider when selling naked puts besides the risk of assignment. Let's say that in my Suncor trade, the stock had fallen dramatically in the past month below $30. Not only would I be in danger of requiring more than 20% margin, whatever event that caused the stock to drop is probably driving the implied volatility of the option much higher too. So even if the put was only $8 or $9 in-the-money, it could have another dollar or two of time value because of implied vol. Thus, if something occurred to change my opinion of the stock and I just wanted out before potential assignment, I would be paying even more to exit.

Can I Close the Short Put Anytime Before Expiration?

I have strongly emphasized the risks and obligations of the short, or "naked," put for a good reason. I don't want anyone to think of the strategy as purely a premium income strategy. You have to think like an investor and do this only with stock or securities you are prepared to buy. That said, can you sell puts and buy them back before assignment or expiration, for either a profit or a loss? Yes, and I do it all the time. Now, that might sound contradictory to some of you. On the one hand, I tell you to develop an investment thesis where you are prepared to buy the stock, and on the other, I say "cash out" before you would have to do so.

Here's the way I look at it. First, my level of conviction when I sell a put is that I am comfortable buying the stock at the strike price, less the premium I collect upfront. If it happens, great; if not, I got paid for taking the risk. This is similar to the way many covered-call sellers think of "renting their shares." When we sell a put, we are using our capital to make a promise. As long as we hold that promise (i.e., as long as we are short the put), we are getting to keep some portion of the risk premium we sold it for.

Second, I usually sell puts after a stock has declined and I think it's about to turn higher again. This could be a 52-week low, or a pullback to recent support. And it's an especially juicy situation when the stock has made a rapid (and often irrational) decline that spiked implied volatility,

as was the case

with my recent

Veeco

(VECO) - Get Free Report

trade. Whatever my fundamental and technical rationale, I expect the stock to act bullishly, and I like the risk/reward of selling puts to capitalize on it. If the stock makes that move fairly quickly after I have sold the put and I can buy it back for less than half of what I sold it for, I consider that a nice, quick turnaround on my money. I'm not running scared, because I never was scared the stock would go lower -- I wanted to buy it down there if I could! But if the market hands me quick payment for my risk, and I can free up margin capital for use elsewhere, I will close the position.

I also tend to do this more for

OptionsProfits

because I suspect that many of you would prefer taking two-thirds of the potential profit on a short put and move on to another idea rather than wait around another month or two (or three) until expiration to collect the full amount.

What's My True Return on a Short Put?

Just as we calculate the "if-called" rates of return for covered calls, we also speak of "if-put" returns. I am not going to go into the math in detail here (you can find examples at the OIC or CBOE sites, I believe), but I will briefly explain so that you see what the true risk/reward is. The most conservative way to think about it is that the amount of premium you end up keeping should be divided by the amount of capital required to buy the shares. Therefore, in my Suncor trade, I needed $38 to buy the stock if assigned. $2 divided by $38 equals 5.26% for whatever time period I held the put. If I buy the put back early for $1, my return now is only 2.63%.

Speaking of covered calls, it's worth noting that a naked or "cash-secured" put has the same risk/reward dynamics as the stock-call combo. Both have long exposure to stock on the downside, with limited profit potential if the stock rallies. This is a fundamental relationship between calls and puts that is defined by their abilities to replicate one another. It's useful to learn more about this so that you understand equivalent and synthetic positions. But that's a column for another time.

Think Like an Investor, Act Like a Trader

Dr. Price likes to sell far-dated in-the-money puts. This strategy is built on his foundation of fundamental analysis for the stock, where he is highly confident about a longer-term rally, very comfortable buying the shares if it doesn't happen right away, and he's getting paid big chunks of cash for his time and risk that reduce his margin requirements and give him more flexibility, especially in an account with portfolio margining. (I should note that puts are seldom exercised early to the same degree that calls are in dividend names. So when your short put still has six to 12 months of life left, you can reasonably expect less than a 25% chance of being assigned if the put goes in-the-money.)

I hope this introduction to short puts has helped put their usefulness into perspective. I always speak of options and their strategies as power tools, and this one is no exception. It can be used for precision strikes as well as heavily levered directional plays.

Check out my plays

on

Chesapeake

(CHK) - Get Free Report

to see how I sold puts to buy calls -- often called a "risk-reversal" -- to increase my directional leverage for less capital.

If you think like an investor and can use your capital for the best plays, selling puts may offer you more consistent profit opportunities in the long run than buying calls. And you've really got the best of both worlds when you can trade around your investments with complete calm, banking trading profits every month while building investment positions that make sense for your longer-term plan.

At the time of publication, Cook was short SU puts and CHK puts and long CHK calls.

Kevin Cook was a high-frequency institutional FX market maker for nine years where he traded over $100 million in currencies per day in the hyper-kinetic world of spot-futures arbitrage. In 2008 he became a lead options instructor for the development of The Options News Network at ONN.tv, an online education community built by the powerhouse Chicago trading firm PEAK6 Investments, LP. Kevin also represented PEAK6 as a market analyst, appearing on CNBC, Bloomberg, CNN, Reuters and FOX Business to offer commentary on equities, commodities, and currencies. Currently he writes an FX strategy column at www.TradersReserve.com and is developing an FX trading course to be offered in early 2011.

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