The Naked Put (Part IV)

In my last post on 3/25/12 (http://www.optionfanatic.com/2012/03/25/the-naked-put-part-iii/), I continued analysis of an AAPL 510 naked put income trade.  I concluded the max risk on this trade to be $102,000 if overlapping trades both take assignment, but this is highly unlikely for a couple reasons.

First, AAPL stock would have to drop over 15% to reach $510/share.  AAPL stock has not dropped this precipitously in years.  This is over 90 points, which would be nine times the daily average true range of the stock over the past 15 days.

Second, the conditions by which assignment is most favorable are not present at this time.  Assignment most commonly occurs just before a dividend is issued or near option expiration when virtually all time value has decayed from an option (hold that thought for a later blog post).  With 33 days to option expiration, in order for our 510 put to be at risk for assignment and lose most of its time premium, AAPL stock would have to fall at least 30%.

Suppose AAPL stock fell to the strike price of $510 on Trade Day #1.  The risk graph would look like this:

The trade is now down $4,500.  That’s much less than the max risk we calculated of $51,000 for one trade.  The more time it takes for AAPL to fall to 510, the less this loss would be.  This is diagrammed by moving step-by-step up the series of dotted lines.

In order to lose more than $4,500 on this trade, AAPL would have to fall below $510.  The longer we are in the trade, the farther below $510 AAPL would have to fall.  I’ll fudge this a bit to account for slippage and say the max loss would be $6,000 rather than $4,500.

For all practical purposes, then, if we enter a contingent order to exit this trade when AAPL hits $510, the max risk would be $6,000.  Even if we had overlapping positions, this total is $12,000.  The monthly return on this trade is now $240 / $12,000 = 2%.  The annual return could be 24%.

The question to always ask is, “would there ever be a case where I would need more than $12,000 to hold this position?”  I believe the answer to this question is yes.  I will continue with the analysis in future posts.