Expected Returns On Naked Put Writing (15:20)

By Lawrence G. McMillan

This article was originally published in The Option Strategist Newsletter Volume 15, No. 20 on October 26, 2006.

We have written a couple of articles recently on naked put writing and put credit spreads as alternative strategies to covered call writing. We are not going to re-hash all of that previous information (although we will summarize it). Rather, this short article is mainly to address the topic of what sorts of returns can one expect from naked put writing – and what do they mean?

Many covered writers prefer to conduct the strategy on a cash basis – buying shares for cash and selling the option premium against those shares. The premium can then be withdrawn and used for whatever the writer wants – as long as he is willing to have the stock called away.

Covered call writing, however, is equivalent to naked put writing (both have profit graphs with the same shape: limited profit potential and potentially large losses on the downside). So, some investors practicing the strategy would rather sell naked puts than operate a cash covered writing program. The naked puts are more efficient in that they involve only one commission and one bid-asked spread, instead of two. Furthermore, the naked put writer has leverage available to him, if he wants it (leverage can be controlled by the investor, merely by deciding how much of his capital he wants to allocate to a particular trade).

As an aside, covered call writing in a margin account is a rather passe strategy – obviated by the naked put strategy. In other words, if you want leverage in the covered call strategy, use naked puts rather than writing covered calls on margin.

A reader – and purchaser of our Expected Return Calculator – asked the following paraphrased question, which was the impetus behind this article: “I calculate the expected return of your Humana (HUM) naked put recommendation as 9.25% [editor: in last week’s Hotline, we recommended a HUM Nov 60 covered write]. This expected return seems rather high, don’t you think?”

Before answering the question, let’s verify the figures. Actually, different investors are going to have different collateral allocations for a strategy in which naked options are sold. One could use the exchange minimum margin requirement as his investment, although we do not think that’s wise, for you would receive a margin call as soon as the stock began to decline in price. Rather, we prefer to allocate 20% of the strike price plus the initial put price as our collateral requirement.

So, in this case, the reader was selling the HUM Nov 60 put (HUMWL) for 1.15, with HUM at 66.50. The expected profit (available from the Calculator) of that sale is 0.89. In other words, over a large number of trials, if one held the position until expiration, he would average a profit of 89 cents on the sale of this put.

Once the expected profit has been determined, one can determine the expected return by using his own collateral allocation as the investment. In our case, that would be 20% of the strike price (60) plus the put price of 1.15. That’s a total allocation of $1315 per naked put sold. Thus, using our collateral requirement, we have: Expected Return = Expected Profit/Collateral Rqmt = 89 / 1315 = 6.8% (if one had used the exchange minimum collateral requirement: 20% x 66.5 + 1.15 – 6.5 = 7.95, the expected return would be higher: 89 / 795 = 11.2%. The reader obviously had used something in between those two to arrive at an expected return of 9.25%).

In any case, these returns are for a trade that is to be held for 4 weeks, so to annualize, one would multiply by 13 – making even our most conservative estimate of 6.8% return an annualized expected return of 72%. The others would be higher (annualized).

So, the question boils down to: can one really expect to make returns of this sort from selling naked puts. The answer is a qualified “yes.”

First, annualizing can be misleading. Who is to say that 4 weeks from now, when the HUM puts expire, that there will be another acceptable put sale that offers a similar expected return?

Second, this 72% is the return on invested capital – the return we can expect to make on the $1315 we are allocating to this position (per naked put sold). But it is certain that our entire account is not going to be invested in this trade, nor is our entire account going to be fully invested at all. There will likely be some excess capital sitting in our account at all times. That will lower the overall returns that one might expect from this (or any other) strategy.

Third, this doesn’t take into account what one’s risk tolerance might be. In theory that 89 cents expected profit doesn’t guarantee that HUM won’t plunge 15 or 20 points on some bad news – sticking you with a huge loss on this one trade. It would take a lot of other profitable put writes to make that back. Hence, any sensible investor is going to limit his actual risk by only selling a small number of these puts.

So, to answer the question: yes, in theory the annualized return of 72% (or higher, if you use a more lenient collateral allocation) can be expected. But, in reality, the factors mentioned above will reduce those expectations. It’s difficult to ascertain exactly how much that reduction will be, but we usually tell prospective investors in our managed covered writing and managed put selling accounts, that naked put selling will likely give one a leverage factor of approximately three times that of cash covered writing. Since we aim for annualized expected returns of 12% or higher on a cash covered writing basis, that would indicate that naked put writing would generate returns near 36%. Even so, returns are likely going to be worse in bear markets and/or in times of low implied volatility.

This article was originally published in The Option Strategist Newsletter Volume 15, No. 20 on October 26, 2006.