By using options, investors can do everything from mitigating downside risk to increasing potential return through leverage. Indeed, there are countless other possible strategies, including a litany of exotic ones, that have been tried and tested, many of which continue to see wide use to this day.
Among the more basic strategies is selling naked puts. This strategy has appealed to a number of investors in recent years in light of the seemingly unstoppable bull market, and is one in which Warren Buffett (Trades, Portfolio) has dabbled from time to time. But is it really worth it?
Getting naked for cash
Before diving into a discussion of the potential merits of selling naked puts, I think it is worth taking a moment first to explain what they are and how they work. Investopedia offers a succinct and clear definition of naked puts:
"A naked put is an options strategy in which the investor writes, or sells, put options without holding a short position in the underlying security. A naked put strategy is sometimes referred to as an 'uncovered put' or a 'short put' and the seller of an uncovered put is known as a naked writer. The primary use of this strategy is to capture the option's premium on an underlying security forecast as going higher, but one which the trader or investor would not be disappointed to own for at least a month or maybe longer."
Put simply, the seller of a naked put benefits when the underlying security goes up, with the breakeven price set at the option's strike price. The seller also pockets the premium from the sale of the option.
Profiting in the state of nature
On March 4, Barron's published an article by investor Steven M. Sears extolling the benefits of this strategy. This was his core argument:
"The easiest way to buy more stock is buying more stock, but selling bearish put options positions investors to buy the stock at a potential discount to its market price. Investors almost always overestimate the likelihood that stock prices will decline, and they often pay too much to buy bearish puts, especially index options, to hedge. Sellers of those puts can often profit by collecting the fear premium. An added benefit of cash-secured put sales—the money to buy the stock is set aside in a cash account—is that they often offer attractive returns on invested cash if the stock remains above the put strike price."
According to Sears, investors can benefit from selling naked puts because they are an easy way to make money by pocketing the "fear premium" with little risk. Sears cited Buffett, whose Berkshire Hathaway (BRK.A, Financial)(BRK.B, Financial) has sold naked puts in the past.
When the music stops
The idea of booking a regular stream of profits by safely selling mispriced risk securities has obvious appeal to a value-biased investor like myself, and Buffett's apparent imprimatur raised my eyebrow. Buffett's optimism about the long-term success of both the U.S. stock market and the U.S. economy might suggest such a strategy.
However, markets have been known to falter. Indeed, one of the few certainties about the stock market is that every bull market will eventually give way to a bear market, though the severity of corrections has varied widely throughout history. Consequently, a strategy that is built on the assumption of sustained robustness in the stock market appears risky to me.
Should the music stop too abruptly, it would be bad news for anyone who sold a bunch of naked puts.
Disclosure: No positions.
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