Naked Put Selling in a Potentially Bearish Market

A classic guide to hedging naked puts when markets feel unstoppable—but risks still lurk beneath the surface.

With the market surging to new highs after a relentless rally since mid-April, it's easy to get lulled into complacency. This 2009 article, written during a powerful rebound following the 2008 crash, offers timeless insights for put sellers navigating an uncertain environment. While current volatility levels are subdued compared to 2009, the core principle still applies: when selling premium, be prepared for the unexpected. Hedging strategies like put ratio spreads or selectively using $VIX calls can help manage downside risk if the bullish momentum suddenly reverses.

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This article was originally published in The Option Strategist Newsletter on April 17, 2009.

Since the “crash” last fall, option premiums have remained extremely high. In fact, in some cases, the implied volatility of out-of-the- money put options has been substantially higher than actual volatility. Thus, put selling (or the companion, equivalent strategy – covered call writing) has been profitable. The strategy has been espoused by many option strategists, including ourselves. It has been touted on television and even by many who really don’t seem to have much of a background in option trading. Usually, when a strategy becomes so popular, an unknown problem often lurks. Problems for put sellers occur in one basic form: the underlying declines in price, rapidly. Maybe nothing untoward will surface, but it doesn’t hurt to plan ahead.

So, in this article we are going to take a look at strategies that put sellers might employ to mitigate, hedge, or otherwise lessen the effects of a bearish market.

Readers might rightfully ask, “What bear market? Isn’t it over?” Perhaps, but there are plenty of astute analysts who don’t think it is. As you know from the articles we have published in recent issues, there were five rallies during 1930 to 1933 that were larger than the one we’ve experienced since the March lows. Even though there was no television financial station to cheerlead the bulls through those rallies back then, I’m sure the mindset was quite bullish each time it happened – much as we see now. Yet, new lows were consistently registered after each of those rallies. As long as that possibility exists, put sellers should be mindful of the downside.

There are many ways that a put seller can hedge risk, but they generally boil down to two simple methods:

1) buy some other puts to hedge the ones you are short, or 2) buy some $VIX calls. Within each of these hedging strategies, there are myriad approaches. We’ll look at a couple.

Put Credit Spreads

One way to reduce the risk of a naked put is to buy another put on the same underlying instrument, where that long put has a lower strike than the one you’ve sold. In that way, your loss is limited to the width of the spread – the difference in the strikes.

While this strategy appeals to many novice traders and is simple to use, it has its own set of problems. The first is that you are now risking 100% of the money in the position. Let’s use an example to demonstrate this:

Example:
SPY: 85
May 71 put: 0.30

If this put were sold naked, we’d allow about $900 as the expected investment. Thus, SPY would have to decline to 62 or so – without any defensive action on our part – before we’d lost the entire investment. That wouldn’t normally happen, as we stop ourselves out as soon as the underlying drops below the strike of the written put.

Now suppose that one considers the purchase of the May 67 put for 0.15 to hedge the May 71 put. The margin required is the difference in the strikes – $400, less the $15 credit received (plus commission). In this case, if SPY is below 67 at May expiration, the entire investment would be lost – a more probable event.

We have written at length about put credit spreads in the past. They are a moderately useful approach – but one which we don’t prefer. In general, the purchase of that deeply out of the money put is usually counter to the strategy at hand. Simply stated, if one put is a “good” sale – meaning it is statistically expensive – then a deeper out- of-the-money put is likely to be even more expensive, and thus is not a “good” buy.

Moreover, many traders find themselves using too much leverage when put credit spreads are involved, for one can sell a lot of them, as compared to a naked put, because of the lower margin requirement. But it is not hard to lose a very large part of your investment – perhaps even 100%. Therefore, as we showed with our condor studies in the past, one should keep his investment in put credit spreads to about one third of his account size at any time.

But the advantage of knowing the absolute risk is comforting to some traders, and thus put credit spreads are viable for them. This would be especially apropos if one does not have time to monitor naked option positions on an ongoing basis. Also, if the underlying is especially volatile – perhaps being susceptible to gaps – the put credit spread might make sense as well.

Put Ratio Spreads

This is a strategy that has certain theoretical advantages over both a straight put sale and a put credit spread, especially in a declining market. Thus it often makes an attractive hedged strategy when conditions turn bearish.