Many option traders like the sound of selling naked puts and for good reason. Generally, the potential premium is nice and depending on the strike that is sold, the odds are on the option trader’s side. Add an expected earnings announcement with elevated premium and it seems like you cannot miss, right? Let’s take a look.

‘This Trade Cannot Lose’ 

Traders often think selling naked puts is low-risk strategy that can offer consistent profits, and indeed it very well can be. The strategy is to sell a put without having a long position, generally with the same expiration. If assigned, the option trader takes control of 100 shares at a cost of the strike price minus the premium received. Many investors will use this option strategy and call it a cash-secured put because they have the cash in their account to cover the cost of the shares of stock. However, selling naked options can be dangerous especially for new option traders and should be left for more advanced option traders and those with large trading accounts.
 
Short-option premium can seem like an easy way to make a profit in trading. What traders forget is that the premium received from selling options is not theirs to keep until the position is closed for a profit or it expires worthless. Even though the premium may seem like a gift, it isn’t. The risks of selling options can be significant.

Implied Volatility and Earnings

 When earnings season is upon us as it is now, the implied volatility of many options increases tremendously making it more tempting to sell puts. When implied volatility is considered high, it can be a good time to sell premium like a naked option. Generally, after the announcement, the implied volatility starts to decline, which is good for naked option traders. That being said, it is considered even more speculative if the position was held over the earnings announcement. A volatility event like an earnings announcement can produce some unpredictable price action for stocks.

Recent Example

Home Depot Inc. (HD) is expected to announce earnings Aug. 17. The stock is currently trading around $325, and it has a potential support level around $315 from the 50-day moving average at that level. A trader can sell 10 August (Feb 20th) 315 puts for 3.50 each. As long as HD stays at or above the $315 level, the premium of $3,500 ((3.50 X 10) X 100) is the trader’s to keep. Even if the stock drops a little below the $315 level, the option trader can profit. The premium received offsets some potential losses and makes the breakeven point of the trade $311.50 (315 – 3.50) at expiration.
 
There is a fairly high probability of success with this trade because the short strike is out of the money (OTM), but many traders fail to limit their losses when the stock moves against them. Depending on the move, particularly after earnings, many naked option positions can wipe out all or a significant part of their accounts. What many traders fail or forget to realize is that each option contract usually represents 100 shares of stock. Getting back to the example, if HD traded down to $305 (just $10 below the strike) at expiration because of earnings, a loss of $6,500 ((10 X 1,000) – 3,500) would be incurred because of the 10 contracts. A seemingly high probability trade with the odds in your favor trade to collect $3,500 has now become a sizable loss.

Last Word

Option traders need to be extremely careful if they choose to sell naked options whether premiums are overpriced (as in around earnings) or not. If a trader decides the risk of selling naked options is worth the reward, the best environment to be selling option premium is when implied volatility is higher than historical levels but not over an earnings announcement.

John Kmiecik, Market Taker Mentoring