The Naked Put (Part III)

Option income trading purports to generate consistent profits on a daily basis.  As defined in my post on March 20 (http://www.optionfanatic.com/2012/03/20/the-naked-put-part-i/), an option income trade is a positive theta position.  The exemplar I have been studying is an April 510 naked put on AAPL (see http://www.optionfanatic.com/2012/03/22/the-naked-put-part-ii/).  The profit potential for this trade is $240/contract.

To better understand this trade, we need to know the risk.  If AAPL sinks below $510 then the naked put could be assigned.  The max risk of this trade is therefore $510/share * 100 shares = $51,000.  While your stock would most probably have significant market value, in the worst-case scenario with AAPL stock crashing to zero, you would be out $51,000.  The max potential return on this trade is therefore $240 / $51,000 = 0.47%.

Repeating this sort of trade every month would roughly generate an annualized return of 0.47% * 12 =  5.6%, right?  Not exactly.  With the trade being placed with 33 days to expiration, the possibility is great for two overlapping positions to be on at once.  The max risk therefore has to be 2 * $51,000 or $102,000.  This now yields a max annualized return of 2.8%.

While 2.8% is a very small return, realize how conservative this trade is.  AAPL would have to fall 15% within 33 days in order for the profit not to be made on this trade.  If you look back on a price chart, you’ll find it has been years since AAPL has fallen 15% in 33 days.  Anything is possible, but because this would be such a rarity, many market observers would consider this trade to be reliable like an ATM machine.

Is this an accurate portrayal?  I’ll cover some further insights in my next post.