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:

  • NFLX Common Stock: $100
  • NFLX Dec $100 Put: $20
  • NFLX Dec $100 Call: $19.50
  • Selling a naked put is a mildly bullish strategy in which the investor (option writer) is selling to the counterparty (option buyer) the right to sell the underlying stock (Netflix in this example) to the investor, on or before the expiration date (December), at the strike price ($100 per share). The investor will receive the premium ($20 per share) from the counterparty. In the example above, the investor believes that the price of Netflix will go up or at the very least not drop precipitously below his or her breakeven price.

    What is that breakeven price? It is simply the strike price ($100) minus the premium ($20), which equals $80. Hence, if Netflix closes above $80 at expiration, the investor makes money, and if Netflix closes below $80 at expiration, the investor loses money.

    The most that the investor can make in naked put-selling is the full value of the option premium received from the counterparty. In this case, that would be $20. The maximum profit would be earned on the trade in the event that Netflix stock price was at or above $100 at expiration.

    How much can the investor stand to lose? The worst-case scenario is that the value of Netflix stock goes to $0. In that event, the counterparty will sell the investor worthless stock for $100. The investor already received $20 from the counterparty, thus mitigating the loss somewhat to a maximum of $80.

    A graphic representation of the naked short put strategy is depicted in the chart below:
    Gain (Loss) Naked Short Put

    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:
    Gain (Loss) First-in-the-Money Call Purchase

    Comparison

    Let's compare the two strategies by overlaying both payoff charts together. Here is what we get:
    Nake Put vs. ITM Call

    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.

    At the time of publication, Rothbort was long Apple, although positions can change at any time.

    Scott Rothbort has over 25 years of experience in the financial services industry. He is the Founder and President of LakeView Asset Management, a registered investment advisor specializing in customized separate account management for high net worth individuals. In addition, he is the founder of TheFinanceProfessor.com, an educational social networking site; and, publisher of The LakeView Restaurant & Food Chain Report. Rothbort is also a Term Professor of Finance at Seton Hall University's Stillman School of Business, where he teaches courses in finance and economics. He is the Chief Market Strategist for The Stillman School of Business and the co-supervisor of the Center for Securities Trading and Analysis.

    Mr. Rothbort is a regular contributor to TheStreet.com's RealMoney Silver website and has frequently appeared as a professional guest on Bloomberg Radio, Bloomberg Television, Fox Business Network, CNBC Television, TheStreet.com TV and local television. As an expert in the field of derivatives and exchange-traded funds (ETFs), he frequently speaks at industry conferences. He is an ETF advisory board member for the Information Management Network, a global organizer of institutional finance and investment conferences. In addition, he is widely quoted in interviews in the printed press and on the internet.

    Mr. Rothbort founded LakeView Asset Management in 2002. Prior to that, since 1991, he worked at Merrill Lynch, where he held a wide variety of senior-level management positions, including Business Director for the Global Equity Derivative Department, Global Director for Equity Swaps Trading and Risk Management, and Director for secured funding and collateral management for the Global Capital Markets Group and Corporate Treasury. Prior to working at Merrill Lynch, within the financial services industry, he worked for County Nat West Securities and Morgan Stanley, where he had international assignments in Tokyo, Hong Kong and London. He began his career working at Price Waterhouse from 1982 to 1984.

    Mr. Rothbort received an M.B.A., majoring in Finance and International Business from the Stern School of Business, New York University, in 1992, and a B.Sc. in Economics, majoring in Accounting, from the Wharton School of Business, University of Pennsylvania, in 1982. He is also a graduate of the prestigious Stuyvesant High School in New York City. Mr. Rothbort is married to Layni Horowitz Rothbort, a real estate attorney, and together they have five children.