In today's video, I want to cover a custom naked put option. What we call a custom naked put also carries many other names out there in the trading world, but this is what I’ve always known it to be, is just a custom order, a different way of building two different strategies into one single trade and order.
This strategy is one we like to use when we're fairly bullish on a stock, but also might see some downside risk of the stock possibly heading lower short-term, so we want to build some of that into our strategy. This is how we setup the strategy.
The first thing we’re going to do is we're going to sell an out of the money call at a very high probability of success level and then what we’re going to do is we’re going to buy an out of the money call at a higher strike and create a credit spread.
We’re going to sell the first block of this strategy, is selling a credit spread at a high probability of success out of the money. The next thing that we’re going to do is go down below the market and sell a naked out of the money put option well below the current stock price.
Because you’re trading an undefined risk position, your risk is theoretically unlimited with this strategy. This is an unlimited risk strategy and your broker will only collect the initial margin required which is used for determining your position sizing.
We’ve got a great downloadable PDF at optionalpha.com for members to download that can help you with figuring out your position sizing. Ideally, what you want to do is that you want to make sure that you do this trade for a credit that is greater than the width of the call spread that you have sold.
In our case, we’ll be doing an example here with SPY where we sold a $1 wide call spread, so we’d be looking to take in a credit that is greater than that width, so that you have no upside risk in this trade and that's ideally how you should set them up.
Profit potential can vary depending on the different strikes that you select and the width and the credit received. The total profit that you get is your total credit received only is then maximized if the stock settles first below the call spread that you sold and above that naked put.
It’s basically on this payoff diagram. It’s right inside those dotted lines that we have vertically. That's where we see our profit maximize when the stock settles in between our range and all of our options expire worthless.
Because we’re net sellers of options on both sides of the market, we definitely want to maximize the volatility edge we get by placing these trades during only high implied volatility situations. Drops in implied volatility definitely have a positive impact on this position.
That also means that if you place this trade in a low implied volatility market and volatility rises, you definitely have the ability to lose money just because of the implied volatility rise.
Time decay as well is going to help this position because we’re definitely looking to collect premium sold on both sides of the market. Theta decay in all of our options is going to work to our favor and the closer we get to expiration, the faster our profit will materialize.
As far as breakeven points, the calculation is pretty simple in these strategies. You take an out of the money put strike that you sold (remember, that’s that naked put well below the market) and you subtract your net overall credit received from the trade.
You’ll subtract that out and that gives you your new breakeven point to the lower side, assuming that you take in an overall credit on this trade and have no risk to the upside.
Let's go to our broker platform here on Thinkorswim and we’re going to take a look at doing one of these custom naked puts in SPY.
SPY is currently trading at about 203.08 and what we’re going to first do is go out of the money on the call side and try to sell a very high probability of success call spread. We’re going to do this today by focusing on the March 210/211 call spread.
This call spread has about a 24% chance of being a losing trade, so about a 76% chance of being a winning trade, so it’s a very high probability of success call spread. First thing we’re going to do is we’re going to go ahead and sell this vertical call spread, the 210/211 and we’re going to take in a $31 credit.
What we’re trying to do is we’re trying to take in an overall credit that’s more than the width of the strikes, so that we take in a net credit on the trade and have no risk to the upside.
Basically, what we’re going to be doing is trying to get a credit total that's more than the width of the strikes which is $1 in this case and what we’re actually going to do is try to get in a little bit more than just $1.
We’re going to go down actually to about the 185 strikes, those also have about a 17% chance of being in the money at expiration or losing, so they're very high probability of success put option below the market and we’re going to sell that option as well, naked.
You can see our credit now has increased to a total of 183. This more than covers the $1 width of the strikes on the call side which is the 210/211 and having this naked option gives us undefined risk to the downside.
This is what our profit and loss diagram looks like, very similar to what we have. We have this undefined risk side from 185 down and in between here, we have a little bit more of a profit range before it levels out above 211.
Let me zoom in here just a little bit more and show you what this looks like. You can see it has that weird looking shape right here which is where the call spread is, but you see we have no risk to the upside past 210/211, so there’s absolutely no risk and in this case, we keep about an $83 credit after everything is said and done.
Even if the market rallies much, much higher from where it’s at, at 203, we still keep an $.83 credit on this trade which is the 183 overall credit less the dollar which is the width of the strikes on the call side because that will be in the money at expiration.
If the stock does end up falling, our new breakeven price is down here around 183.20, so it’s much, much lower than where the stock is trading right now. This is such a great strategy to use when implied volatility is high because you can see it gives us a huge profit window on this trade.
If we actually go to the charts of SPY, you can see that our breakeven price from where the stock is trading right now is down around 183 which is somewhere right about in this range and you can see the stock is trading currently at 203.
In just the next month and a half, the stock market would have to basically crash for all intensive purposes for us to lose money on this trade. You can see it’s a very high probability of success trade and our window for making the maximum credit goes all the way up to 210.
We would actually only make (I say only because we’re still making money) $83 past about 210/211. It's a really, really good strategy, one that we really favor here at Option Alpha, but it just is so important that you make these trades only when implied volatility is very high.
A key takeaway for this strategy is that you can also think of this strategy as entering an iron condor without the put side protection or that additional long put on the bottom side.
We definitely suggest that you enter this trade for a net credit greater than the width of the call spread strikes, so that you maintain no additional upside risk and it just increases the likelihood that you make money on this trade.
As always, I hope you guys enjoy these video tutorials. If you have any comments or questions, please ask them right below in the comment section on the lesson page. Until next time, happy trading!