Institutions, portfolio managers and individual investors try to buy their favorite stocks at discount. Once they determine that a particular stock needs to be in their portfolio then they just wait for the stock to come to their buy price point and then they start accumulating their stock.
Let’s say they want to include AAPL in their portfolio. However, AAPL has already moved up for a week and trading at $119 and they think that AAPL needs to pullback towards $110 and then they would pull the trigger as they think AAPL will be trading at $150 in future.
One strategy is to simply wait for AAPL to come down to $110 and then buy. However, they may miss buying AAPL altogether as AAPL could come down to $112 and starts to rise again and instead of coming down to $110 moves toward $115, $120, $125 and then $135 and eventually reaches $150. In other words, investors may miss the boat.
In order to avoid such situation, these big investors take advantage of writing naked Puts and collect the premium and thus either buy AAPL at discount or get paid for their efforts. The process works as follows:
Let’s say AAPL is trading at $119 on November 24, 2015. March 110 Puts are selling at bid $3.55, ask $3.65. This means an investor-A can write a naked Put for $3.55 per contract, thus collecting $355 per contract (as one contract controls 100 shares). If investor-A is planning to buy 1000 shares of AAPL he can write 10 naked Puts in AAPL and thus collect $3,555 in premium (minus commission, which is negligible these days).
Let’s say after writing the naked puts, AAPL, during next four months, comes down and trades at $108. The investor-B who is holding the puts (bought puts from Investor-A) has the right to sell 1000 shares of AAPL at $110.00. Thus naked put writer (Investor-A) will be assigned 1000 shares of AAPL at $110 per share. However, since the naked put writer already collected the premium of $3.55 per share therefore, his cost for AAPL share would be $106.45 ($110-3.55).
Thus instead of waiting for AAPL to come down to $110 and then execute the buy order, investor-A wrote naked puts, collected $3.55 per share and waited patiently for AAPL to come down to $110. However, if AAPL rises upward after writing the naked puts then investor-A gets to keep $3.55 per share. On the other hand, if AAPL comes down below $110 then investor-A is assigned 1000 shares of AAPL at $110 per share and net cost would be $106.45.
In other words would be Investor-A of AAPL is getting paid for his patience and efforts.
One drawback to this technique is that if AAPL does not stop falling at $108 and drops to $105 then investor-A will be losing $1.45 per share. However, the assumption is that investor-A wants to buy AAPL shares at $110 and thinks AAPL will go to $150 in future.
Since investor-A is doing naked put writing therefore, he needs to meet margin requirements from his broker and needs to know exactly how much cash he needs to have in his account at the time of initiation of the trade and in case AAPL drops to $110 or $105 or $100. As AAPL falls towards these prices, his margin requirements will increase. The advice experts give is not to write too many naked puts as it can backfire. There is no Free Lunch in investing world!
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