Should I Sell Naked Puts?

Question from a reader

Black Monday
The Agony of a Naked Put Seller. Goole Images

Question from a reader:

I just want to know what you think about generating income from selling far-out-of-the-money index options, such as on the Amsterdam index or SPX index, I read one book that suggests selling FOTM index put options with expiration of 2 to 6 months. I think this is safe because the far strike price and far expiration, combined with our exit strategy of getting out of the position if the strike price is touched, or the premium doubles or triples.

Selling FOTM Naked Index Puts

There are two very different ways to think about the strategy.

  1. It is fairly safe and will generate a profit between 70 and 90% of the time - depending on which exit strategy you adopt (exit when the option doubles or triples; or the option moves into the money, or when the option Delta reaches a specific level (best)) and just how far out of the money that the options are when they are sold.
     
  2. This strategy is so risky that it must be avoided because it is a pure wager -- with essentially unlimited risk -- that the stock market will not tumble too far.

In my opinion, #2 is is better way -- in fact the only way -- to think about this strategy. Unless you are a very experienced trader who never has a problem with risk management, don't sell naked index put options. You can still sell OTM puts on stocks that you want to own -- as long as you have the cash to make he purchase.

But index options are different. 

Just look at the world as it is today. What would happen if terrorists were able to assassinate two or three world leaders at the same time? Or were able to explode a nuclear bomb in NY or London? Or if Greece had defaulted and had to drop out of the Eurozone? What about a nuclear confrontation between some long-time enemies?

etc. Not only would the stock market decline -- resulting in a loss -- but the implied volatility would double or triple -- and that would increase the price of the naked puts by a very large amount.

People who adopt this strategy always think that they can exit when the option price doubles or triples. And most of the time they can. But if something bad happens, the markets will be in panic mode.  The majority of traders will want to buy puts to protect their assets, thereby increasing the price of all options. Your loss in this situation would be huge. Play with an option-pricing calculator to see just how much cash is on the line. In October 1987, implied volatility moved as high as 150. That may not happen again, but when there is panic, traders who are short put options suffer.

The problem is that one such loss could bankrupt your account -- and possibly leave you in debt to your broker.

I understand that this is unlikely on any given day, or any given month. But if you are always short some put options, then you are always exposed to this high-risk situation. Sure you can use this strategy if you still like the idea, but you have to expect to take a good-sized loss every few years or so.

Think 1987, the 9/11/2001 attacks, 2002, 2008.  There are more such market crashes coming in the future. We just do not know when.

The other main problem with this strategy is that there is a very good chance that it is  going to be nicely profitable - trade after trade.  That brings on the temptation to sell more puts that you had been selling previously. The more money you make, the more you are going to feel safe -- and that is when a trader tends to ignore risk and may increase position size. And when you own a large position, the unthinkable scenario could result in a loss that wipes out a lifetime of savings. Remember: You may have (for example) $50,000 in a brokerage account, but a bad event (when you are naked short put options)  can result in a loss of hundreds of thousands of dollars.

Bottom line: Too risky for me. That is why I always sell put spreads and not naked short options. The profits are less, but there are never any catastrophic losses.