MILLBURN, N.J. (Stockpickr) -- Recently on RealMoney , an interesting debate raged on naked put-selling, in which Jim Cramer and I both professed its dangers. Cramer later addressed naked put-selling in an episode of "Stop Trading!" on CNBC, saying the strategy is too risky and criticizing those who recommend it.So what exactly is naked put-selling, and why is it risky? Naked Short Put-Writing First, we need to understand the strategy behind naked put sales. For this example, I am using some data that I extracted (and for illustrative purposes rounded) for Netflix ( NFLX - Get Report) stock and options:
In-the-Money Call Option Purchase In Cramer's opinion, if an investor has a bullish opinion on a stock, he would prefer for that individual to purchase a first strike in-the-money call option going out two months. A call option gives the buyer (investor) the ability to benefit from bullish moves in a stock via the right to purchase the stock at a given price on or before the expiration date. In exchange, the investor pays an upfront premium. Note that on "Stop Trading!" Cramer used Apple ( AAPL - Get Report) as his example. I will continue using my Netflix example but would like to point out that what I am describing in this article could be easily replicated for Apple using a two-month naked put sale and/or first strike in-the-money call option purchase. For December, there is a NFLX 95 strike call option. I will use $22 as the premium for that call option for the purposes of my example. What is that breakeven price? It is simply the strike price ($95) plus the premium ($22), which equals $117. Hence, if Netflix closes above $117 at expiration, the investor makes money, and if Netflix closes below $117 at expiration, the investor loses money. However, the investor recoups some of the premium paid from stock price outcomes between $95 and $117. The total loss is limited to the $22 premium that was paid. A graphic representation of the in-the-money call purchase strategy is depicted in the chart below:
Comparison Let's compare the two strategies by overlaying both payoff charts together. Here is what we get:
Trading in these two option strategies requires that the investor post margin deposits in order to support the positions. According to the CBOE margin calculator , using my examples , each strategy (on a per-option-contract basis) would have to post initial margin requirements as follows:
Naked Put Sale: $4,000 which is $2,000 for the option sales proceeds plus $2,000 of SMA debits. Essentially the client has to come up with $2,000 of good margin collateral. Long Call: $2,200 for the option purchase. Conclusion Here's what we can conclude by comparing these two strategies: The naked put sale has the potential to generate significant losses. In this example, that would be $80 per share. If you don't believe that can happen, think American International Group (AIG - Get Report) or Lehman Brothers. For this very reason, the naked put strategy can be deemed far too risky. The call option, at least on a theoretical basis, can earn an infinite amount of money. While that is unlikely to occur, the call option certainly has the potential for outsized gains with a lower risk/reward profile. The naked put strategy can outperform the in-the-money call strategy within a fairly wide range of stock price outcomes compared with the current stock price. However, that range is a function of the stock option's implied volatility and thus can vary from stock to stock. In general, the put-writing strategy will yield better results if the stock price tends to trade in a narrower range, or a trajectory of lesser realized volatility between now and options expiration. Margin requirements are nearly identical, so there is no real advantage for one strategy over the other. Of course, this could also vary from stock to stock. -- Written by Scott Rothbort in Millburn, N.J.