If you had naked puts before the market crash, I suspect you’re now wrestling with the question of how to manage your position. Your put has gone ITM, deep ITM. Your losses are likely much higher than you were planning on. The dream of buying a stock at a discount has turned into a nightmare of purchasing at a massive premium.

Let me remind you of your choices and provide insight on how you might manage your way back to a profit, or at least to a smaller loss.

When Disney’s Magic Goes Poof

I’m using Disney stock as an example since it lies at the epicenter of all that ails the world right now. The coronavirus is attacking Mickey from all sides. His cruises? Canceled. Theme parks? Closed. ESPN? Nothing to talk about. Movies? Who’s going to the theater? Poor Mickey.

At this week’s lows, DIS was 48% off its highs.

Let’s say you sold an April $105 put for $3.35. At trade entry, the stock was sitting at $113. Obligating yourself to buy at a cost basis of $101.65 seemed like a great deal. Now it looks like punishment.

What do you do? Let’s review.

Trader or Investor?

You have to decide at the start if you’re using short puts as a trade or an investment. If you’re using it for a trade, then your plan has to be to exit long before the put moves deep ITM. You simply can’t afford to incur a significant loss on a single trade.

My typical stop loss for a naked put trade is to bail if support is broken or the short strike is reached. In either case, the 105 puts should have been exited around March 9th.

I should have sized so that the loss was a small percentage of my account. It hurts, yes, but you live to fight another day.

The Long Haul

If the intent was to boomerang the naked put, then this is where things get interesting. First, you have to make sure you only sell one put for every 100 shares you’re willing to own. Second, you must make sure that you’re account can handle a considerable drawdown on those shares. For example, if assigned on DIS I will be long 100 shares @ $101.65. That means I’ll have $10,165 in the stock. If it gets cut in half from there by falling to $50, I’ll have an unrealized loss of $5,000. Can my account handle that?

The last thing I want to do is end up puking up the stock after it’s declined by 50%. What’s the point in that? I’ve blown my chances at recovery to smithereens. Hopefully, I’ve done my due diligence and picked a stock with healthy enough fundamentals to survive.

The Tricks

I have three ideas for reducing the damage.

Sell calls, scale-in to more puts, buy more shares

Selling calls against your position converts the naked put into a short strangle. Think of it as selling the covered call before you get assigned stock. As the stock drops, you can keep rolling down the call to bring in more premium. And if you can’t sell a naked call, then use bear calls.

For example, let’s say on March 10th, we sold the DIS April $120/130 bear call spread for $1.87 credit. Then, today, with the stock rolling over again, we sold the April $110/$120 bear call for $1.09 credit.

If we end up getting assigned on the stock and captured the credit from both bear calls, our cost basis drops from $101.65 to $98.69.

I could continue selling calls once the put converts to stock to reduce basis further.

More Short Puts or Stock

If I’m able to acquire more shares, I could later sell another put or simply buy more shares to further lower the basis. It’s important when doing this that I don’t allow the position to get too large. If I’m uncomfortable with $10k in DIS, then I’m certainly not going to be okay doubling that to $20k by adding size.

Suppose I acquire more shares of DIS near $60 if it really gets destroyed. That will lower my basis from around $100 to $80, thereby allowing me to recoup the losses quicker. As long as I stick with it, and, most importantly, the company eventually recovers, the unrealized losses gradually go away, and the money returns to its rightful owner.

ME.