Naked Puts Are a Dangerous Game

Options Forum examines the role of leverage and suggests some Web sites for monitoring implied volatility.
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Jargon alert! We're not going to try and "leverage" anyone in this column, but rather explain why leverage can be very risky in options investing. Along with leverage, we'll tell you where to get started in index options and where to find volatility information on the Internet.

As always, keep sending queries to

Options Forum -- and don't forget to include your full name.

Leverage Leanings

I have a question in regard to leverage (from an option seller/writer point of view). First, I typically use options as an overall strategy to increase the yield on the cash allocation in my portfolio. (I am selling put options in the anticipation that they will expire worthless, or alternatively buying desired stock at a price much lower than the current share price.) I am fairly new to the options game, but I am fairly confident that I am not taking on risks that are disproportionate to my return (i.e., mostly writing out-of-the-money puts among several different issues as well as Nasdaq 100 (QQQ) - Get Report, and S&P Midcap 400 index (MDY) - Get Report options). I do not, however, fully understand the relationship between the probability that an option will expire worthless and the options "delta" and leverage represented as: current share price x delta / option price What I have read indicates that the lower the delta, the lower the probability that the option will be exercised. On leverage, however, I have not been able to come to a consensus on whether high leverage or low leverage is good for my put positions (as a seller). -- Fred Underwood

"Wait a second!" screams options investor and trader George Fontanills. Before we go any further, Fontanills reminds us that selling naked put options is actually a fairly risky strategy. "It's one of the worst things you could do in a market that is this volatile and with such risk to the downside," he says.

Instead, he recommends buying a put option below the one sold, creating a "bull put spread," reducing the cost of getting into the trade.

Definitely, Fontanills agrees, the

delta of an option gives you an idea of where the option will close. Delta is the amount the option price will move for every $1 move in the underlying stock.

"When you sell a put, you have positive deltas, and

when you buy a put, you have negative deltas because with puts, you make money on the way down. Selling puts equals positive delta. Fred's overall position will be based on overall delta, so Fred, you're absolutely correct about that probability."

Leverage, essentially, is like gunpowder for your investment. Theoretically, the more risk you take, the more profit you receive. But that also means you should expect to have more volatility on the way to achieving your greater profit, or your loss. (Yeah, remember those.) Sometimes, investors use borrowed money,

a la

Long Term Capital Management

, to juice their investments in the hopes that a bigger bet will lead to a bigger payoff (or a bigger bankruptcy, in LTCM's case).

That doesn't change because you're selling puts.

"Selling naked puts is one of the most risky strategies around," Fontanills says. "By offsetting that bet and buying another put, Fred, you should reduce the cost of capital and leverage with a bull put spread."

Example: With a stock priced at 100, sell the 100 puts and buy the 90 puts, so if the stock breaks down you can dump the shares put to you at 100 for 90 and you won't get ridden all the way down.

Volatility Hunting

I generally don't have difficulty finding information on the Web, but I've had absolutely no luck finding a Web site out there that provides implied volatility figures for options, at least none that are free and none that have a reasonable price without paying for a bunch of other services I don't need. Do you know of any or have any suggestions? I find it hard to believe that such an important piece of information is so hard to find. -- Thad Roe

At the risk of repeating ourselves, it wouldn't hurt to check out the ever-useful

Chicago Board Options Exchange's


site. We know you're looking for implied volatility, but historical doesn't hurt either. Go to the

Trader's Tools

section, where you can find 30-day historical volatilities for optionable stocks.

The CBOE site also offers Volatility Index historical data, which is updated weekly. The


, a measure of the market's fear, is key in taking the temperature of the broader market.

Options dean and author

Larry McMillan

maintains a free volatility information database, updated weekly for historical stock volatility and historical implied volatility on his Web


For index options, we checked out

PM Publishing's

site for implied volatility on index options. As for free stock charts online, one simulating a trader's desk display (albeit with delayed quotes) that has "live" charts and trade recaps side by side is at

George Fontanills, president of

Pinnacle Investments

in Boston, Mass., has in the past plugged his own subscription-based Web

site as a great place for volatility and other data. We include it since there is a free trial.

Index Selling 101

How can I get basic information on selling S&P 500 index puts? Also how do you value the options based on the day's S&P 500 results? --Terry Brophy

Ah, index-put selling. The funeral march of

brave trader. If you want to sell index options puts, be careful. These settle in cash and you can find yourself paying up big if the market suddenly crumbles.

If you're resolute, the CBOE would be a great place to start, especially since the exchange holds the license for the all options on the cash index. (The

Chicago Mercantile Exchange

holds the license for and trades futures on the S&P 500 index).

Visit the CBOE's

Advanced Concepts page on its Web site for enlightenment.

Index options have strike prices that are set at intervals from 1 to 10 points. Like all options, the relationship of the index to the option's strike price determines whether the option is referred to as in the money, at the money or out of the money. For instance, a call option is in the money when the index level is above the strike price. It is at the money when the index level is equal to the strike price and out of the money when the index level is below the strike price.

If you bought an index put with a strike price of 75, you participate in moves in the underlying index below 75. A put option is in the money when the index level is below the strike price, at the money when the index level is at the strike price and out of the money when the index level is above the strike price. CBOE will typically list in-, at- and out-of the-money strike prices.

One of the other important pricing factors in index options -- all options, actually -- is implied volatility. For an excellent resource on pricing your index puts, check out PM Publishing on the Internet. PM Publishing has a free trial for something called

Web POP, an options pricing and risk analysis program, and for a fee access to other info on the site.

The CBOE also allows you to download directly from their site educational packages on index puts and how to properly price options.