There are various techniques for managing a naked put that goes against you. Today I want to discuss what you might do if it moves ITM at expiration. In my Team Phoenix Trading Lab, we’ve been managing a naughty naked put on KBH. Rather than exit at a loss at expiration, we opted to roll out the position to the next month. Here’s a review to bring you up to speed.
KBH Review
On January 13th after KBH gapped higher on an impressive earnings report, we sold a February $43-strike naked put for 50 cents. At the time the stock was $49, so we were OTM. The original plan was to scale-in to a 2nd or 3rd contract if we got at least 75 cents and $1.00 and the stock gave a bullish trigger.
Over the next two weeks, KBH tumbled, driving our put price from 50 cents to a whopping $3.65. We ended up adding a second tier at $2.50 and a third tier at $3.65. By being patient and waiting for the chart to give us a bullish signal, we sidestepped adding more contracts too early.
Ultimately, KBH didn’t recover enough before February expiration to get a profit. Along the way, I exited the 2nd and 3rd tier near breakeven to get smaller and make it where I only had to manage one ITM naked put instead of three.
The day before expiration on Feb 17th, KBH was at $39 placing our $43 short put deep ITM and worth around $4.15. At that point, we had three choices.
- One: Take the $3.65 loss, exit the trade and move on. The advantage is that we don’t lose any more on KBH. The disadvantage is that we have no chance of recouping losses.
- Two: Allow assignment and buy the shares for $42.50 (43 strike minus 50 cent credit). Then, sell OTM calls to further reduce the basis. The advantage is that we have a chance to recoup losses if KBH recovers over the next month. The disadvantage is that it increases the trade cost to at least 50% of the stock cost (if buying on margin), and we can lose more if KBH keeps falling.
- Three: Roll out the put from February to March to dodge assignment while keeping the trade alive. This maintains our exposure so we can recoup losses, but it opens us up to losing more if KBH continues to sink.
Here’s how I choose.
If I’m not in love with the company and only sold the put because of a specific chart pattern, then I’d take route one. And, quite honestly, I probably would have been stopped out well before expiration.
If I like the stock long-term and if it’s a small enough position then I’ll take route two or three. If I didn’t want to tie up as much capital, I’d stick with rolling the naked put. If cost wasn’t an issue and/or I liked managing covered calls better than naked puts, then I’d allow assignment.
For the lab, I chose to roll out the put from the Feb $43 strike to the Mar $41. I paid $4.15 to close the Feb put and received $3.15 for selling the March put. I felt the need to roll down to a lower strike to increase the probability and judged it worth paying a $1 net debit to do so.
Unfortunately, KBH continued to sink. as low as $34. Whether or not someone adds a second or third tier on the new naked put comes down to personal preference. I sold the new put for $3.15, so my add points would have been $4.73 (3.15 x 1.5) and $6.30 (3.15 x 2). In hindsight I should have because KBH staged a huge bounce from Feb 24th to March 2nd that would have allowed us to recoup all the loss had we added size.
In this case, I didn’t add size, so couldn’t fully capitalize on the rebound. That said, we did add a bear call spread near resistance to pick up a few bucks. This is one of my go-to strategies to hedge a losing naked put. By the time March expiration rolled around, KBH was sitting at $38, and our Mar $41 naked put had a small loss. With the gain from the bear call, March was essentially a wash. But, with my naked put ITM, I faced the same choice as February. Once again, I rolled out – buying back the Mar $41 naked put for $3.50 while selling the April $40 put for $3.50.
Fast forward to today. KBH is around $33 and the April $40 put is trading for $7 giving us a $3.50 unrealized loss. I never added size this month because we never had a good enough signal. With the put deep ITM, there’s no time value left even though we have 13 days remaining. This increases the risk of early assignment, so If I’m unwilling to buy shares I’d consider rolling out to May. And, because the April $40 put is so deep ITM, I’d probably want to roll down again.
Let’s assume I close the April $40 put for $7 and sell to open the May $38 put for $5.60. Thus the cost of the roll is a net debit of $1.40. Let’s pretend KBH rallies back above $38 and I capture the entire $5.60 for May. What’s my overall profit?
50 cent original credit minus $1.00 debit to roll from Feb to Mar minus $1.40 debit to roll from April to May equals $1.90 overall loss.
Now, a few points.
- First. I’d be very surprised if KBH returns to $38 by May expiration. The chart looks terrible and it’s altogether more likely the put resides ITM at expiration. If we’re lucky we’ll make back some money this month and then roll to June. If we’re unlucky, KBH will continue sinking and we’ll roll at a loss to a June $37 or $36 strike.
- Second. Would I scale in to a 2nd or 3rd tier with the May $38 naked put? Sure. But only if I get a good bullish signal on the chart. And, if I wanted to take a less aggressive approach, I might not sell as deep ITM.
- Third. If KBH sinks too far, such as below $30, then it may become necessary to dollar cost average by adding more exposure. I can do that via buying shares or just managing a second put at a lower strike. When we took the rolling route with my lab, I told the team that I would only do this if I liked KBH and was confident in its eventual recovery. Moreover, we had to be willing to go the distance and potentially see larger losses rack up in the short run. That is playing out right now.
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