Question - Turning a Naked Put Into a Covered Put After the Naked Put Has Gone In the Money

Can you turn a naked put that has gone in the money into a covered put? Does it have to be the second it goes into the money or before its expiration date?

Answer

Thanks for the question.

I really don't think this would be a very good strategy. The net effect of converting a naked put into a covered put is that it more or less locks in the current results of your situation.

Let me explain -

First, remember that a covered put is when you write a put while shorting 100 shares of the underlying company. And if you short the shares after the put has gone in the money, then regardless of what the stock does at that point, you're not going to see much change in value of the trade.

For example, if the stock continues declining, the amount you gain on the short stock position will be offset by the accumulating losses on the short put as it gains in value (and the deeper in the money the put is, the higher the delta or the closer the correlation between the amount the stock declines and the rate of the put's increase in value).

And what happens if the stock rebounds? Your short put loses value (which is what you originally wanted), but now you're underwater on your short stock position. Again, things kind of offset.

So what you would really be doing by converting a naked put into a covered put is sort of locking in your losses and limiting (but not eliminating) further downside. If you wanted to do that, it would probably be smarter to just close the position altogether.

I don't know your exact situation, so I may be off here, but I'll throw out a couple of other ideas. If you're writing naked puts, you're either doing it as an option income strategy or as a way to acquire shares at a discount.

If you're doing it as an income strategy, I assume that the stock isn't one you're dying to buy and hold. That's the drawback of put writing for income - it's easy to find yourself in a situation where you're dealing with less than stellar stocks because the premium levels are very attractive.

Naked Puts and Bull Put Spreads

To make the trade safer in the future, you can set up bull put spreads instead of naked puts. A bull put spread is the same thing as a naked put except that for each put you sell, you buy one at a lower strike price. The trade still earns a net credit, so it's still a viable income strategy.

It also gives you some other advantages - limits your downside (max loss = the difference between the strike price less the net credit received . . . and you factor in commissions, too, of course), and it even allows you to "flip" the trade by buying back the short put and leaving the long put open.

That can be dangerous and backfire on you, but I've lucked out on that myself and actually turned a losing trade into a winning one as the stock continued to fall after I bought back the original short put and left the long put open.

There's another advantage, although it can quickly become a disadvantage - because your losses are capped to a relatively small sum for each bull put spread, you can set up a whole lot more bull put spreads than naked puts. But over leveraging by setting up too many bull put spreads eliminates altogether the trade's inherrent advantage of limiting your downside.

Hope this helps - best of luck to you and thanks again for the question.

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