Last update: July 2021

Cash flow seekers just love the naked put. And why shouldn’t they? Getting paid for a promise is quite the attractive proposition. Particularly if it’s a promise you’re more than happy to make good on.

Think of it this way. You want to buy a sweater that’s currently $50 at Studs “R” Us but wish you could buy it on sale, say, around $40. You could wait a while continually checking prices to see if the store ever discounts the thing. But what if instead I, the world’s best store manager, came to you with a sweet offer.

Me: You want to buy that sweater?

You: Yeah, but I was hoping to get it on sale for around $40. I mean, my health care insurance is jumping 30% next year (Affordable Care Act? Puh-leeze!) and I gotta reign in my spending habits.

Me: Aye. As the cool kids say, the struggle is real. Well, what if I did this? What if I paid you $2 to obligate yourself to buy the sweater if it drops to $40 sometime over the next two months? If it never gets that cheap you can keep the $2. If it does you’ll have to buy it but can still use the $2 to partially finance your purchase. So, really you’ll only be out $38.

You: Sounds like a win-win to me.

Such is the pitch for the naked put. Of course, buying a sweater for $40 seems like a no-brainer when it currently costs $50. But what if over the next three months cotton production quadruples and sweaters drop to $10 a pop. You’ll feel like a real idiot for obligating yourself to buy one for $40.

Kind of like those who thought buying USO for $14 or UNG at $11 was a steal. Poor souls.

This is the risk faced by naked put sellers everywhere. But, take heart, the veteran’s say. See, if a naked put goes awry you can always roll out. Collect more premium and extend duration to give the stock more time to eventually cooperate.

Indeed, rolling out can rock but it isn’t without its faults. There’s a certain situation where the stock will steal all the time value from that strike price such that you don’t have a choice but to roll out and down. There’s quite a few moving parts so let’s take this puppy one step at a time.

First, did you know what I mentioned above was possible? That stock could essentially steal the time value in an option by undergoing a massive move? It can even cause an option a month or two from expiration to lose all its time value. Yep, it’s sad but some stocks become theta killers. This has to do with the fact that not all strikes have the same extrinsic value. Consider the following graphic (drawn by yours truly) which plots strikes on the horizontal axis and extrinsic value (aka time value) on the vertical axis:

It forms a bell curve illustrating that the amount of extrinsic value peaks in the at-the-money option while diminishing as you move further OTM or further ITM.

This is why option sellers stick with contracts that reside near the at-the-money strike and why selling deep in-the-money or far out-of-the-money options is often viewed as a fool’s errand. There just isn’t enough meat on the bone for time decay to eat.

And herein lies one of the problems with relying on rolling out month after month to save your bacon. At some point, the stock will have dropped so much that the put strike you’re anchored to is devoid of extrinsic value. You can’t score any more extrinsic value by selling the same strike in the next month. I mean, you can still roll out, but with deep in-the-money options the only variable making you money is delta. The stock has to rise to generate some profits. The passage of time means nothing to your option.

And that’s unfortunate. Because that’s why you started selling puts in the first place; to curry favor with Father Time and exploit his tireless work.

So what’s the solution? Well, there isn’t a perfect one (aside from the sarcastic yet oh-so-satisfying response to only sell puts on stocks that aren’t going to drop). You just need to be aware that you will run afoul of this from time to time and whether you like it or not you’ll have to roll down occasionally (for a pesky debit) and thereby reduce the chance that you’ll make back all of your loss. If you want a silver lining, rolling down does at least increase the chance you’ll make back something (lower delta = higher probability of profit). And before you get all depressed I actually do have a few alternate ideas I’ll share below.

Now, let’s illustrate all this with an example. I’ll use the United States Oil Fund (USO) since it’s a favorite among put sellers due to its cheap price tag on account of the ongoing commodity crush.

Let’s say on November 5^th with USO at $14.50 you sell a December 13.50 put for 31 cents. If USO drops, eh, who cares, you reason. I’ll just roll out to the Jan 13.50 put to score some more income and give mean reversion more rope to wrangle the unruly stock and bring him back in the right direction

Good thinking!

Much to your dismay USO continues plumbing the depths throughout the month dropping to a lowly $11.37 by the time expiration week rolls around. Your Dec 13.50 put is now worth $2.15. The time to roll is nigh. So, as planned you create an order to buy back the Dec 13.50 put and sell the Jan 13.50 put. The roll can be entered for a 10 cent credit which means the Jan 13.50 put is trading for $2.25, or 10 cents more than the Dec 13.50 put. The great thing about rolling for the credit is it allows you the ability to make back all of your loss, plus the original 31 cent credit plus the 10 cent credit received during the roll. But that’s only if USO can climb back above $13.50 by January.

But that’s okay, you reason. At least I’ll make some dough due to time decay in my new position even if USO meanders sideways.

You wish! See, the reality is the Jan 13.50 is so deep in-the-money now that it has virtually zero time value. Feeling angry? Blame it on the stock. Its descent stole all the time value from the 13.50 puts by driving them so far in-the-money. Take a look at the time value diagram again. When you entered the trade your put was only slightly OTM boasting plenty of time value (green circle). Now, however, the 13.50 line of puts has moved deep ITM to the red circle. Lame.

It’s dilemma time. Do you throw caution to the wind and stick with the 13.50 line of puts to ensure you can recoup the entirety of the loss and then some? Remember, in doing so you’re abandoning theta as the driver of your trade and now relying solely on delta. If you’re staying true to your theta roots you must, of necessity, roll down to a lower strike, one that’s closer-to-the-money and actually has some theta.

Right now the Jan 12.50 put is trading for $1.40 and has 30 cents of time value. Not a lot, I know, but let’s not be picky at this point. It’s a heck of a lot more than the 13.50 put. If you buy back the Dec 13.50 for $2.15 and sell the Jan 13.50 for $1.40 the roll will cost 75 cents debit. On the plus side, you can now count on theta to chip in throughout the trade (yay!). And yet, because you had to pay 75 cents you’re now unable to recoup the entirety of your loss. And perhaps that’s a worthwhile concession. Whether it is or isn’t doesn’t really matter. You have to do it if you want to continue courting theta.

Or maybe not.

One way you could semi-solve the dilemma is to start your trade with a smaller position to leave the door open for adding more contracts at a different (and closer-to-the-money strike). That way you’d still be short the deep ITM puts thereby giving you the chance to recoup your precious dough should the stock stage a rousing recovery. But, you’ll also acquire some theta from the new short puts that sit close to the money. This allows you to capture some income along the way if USO decides to meander sideways. Lest you didn’t catch all that on the first pass here’s an example.

Say I originally shorted one contract of the USO Dec 13.50 put, when rolling I could go ahead and buyback my one Dec 13.50 put and sell one contract of the Jan 13.50 put. But, in addition, I would also short one contract of the Jan 12.50 put. Yes, I’ve doubled the size of my position – but that’s why I started with only one contract (or whatever constitutes a small position for your account). I’ve also split the strikes between 13.50 and 12.50 to pick up more theta.

A second alternative to pick up some theta would be to sell a close-to-the-money call. Since you’re already short a put this would turn your trade into a short strangle – and an inverted one at that. Sound interesting?

Of course, it does. Do you think I want to pontificate for 1500 words on something uninteresting?

No, son.

I was just about to unveil everything fascinating about inverted strangles but my fingers are going on strike on account of the lengthy workout I just put them through. I shall pick up the topic in my next newsletter.

Stay tuned mi amigos.

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