How Does a Naked Put Lose Value?

3 Ways Short Puts Decline in Value

If you're going to sell put options for income and fun, you're going to want to see those short puts decline in value.

You've heard of "Buy Low, Sell High" - when you're a seller of options, that's still the case, it's just that the transaction orders are reversed.

So you want to sell (to open) high and then buy back (to close) low. Or even better, your short puts can expire out of the money and therefore worthless so you won't even need to buy anything back at all.

The important question then is, "How does a naked put lose value anyway?"

There Are Only Three Things That Can Cause Put Options to Lose Value

Here are the three things that cause a short put to lose value:

The passage of time
A rising share price
A decline in implied volatility pricing levels

The first two factors are the most important.

And while we set up our positions with good ol' time decay in mind, we'll gladly take a rising share price as well (it's just that it's not required for our put selling success).

But because we set up our Sleep at Night trades in a specific way, we do actually see the underlying stock trade higher. And when that happens, we get a positive double-whammy on our trades as the short put loses value more rapidly.

Let's walk through a real world example to illustrate the dynamics involved.

XLNX $67.50 SHORT PUT = 71.50% Annualized Over 7 Days

So with the XLNX position - and this is a trade we did inside The Leveraged Investing Club - I originally sold a JANUARY 19 2018 $67.50 put for $1.25/contract.

One week later, thanks to the big move higher in the underlying stock, I was able to buy that same put back for just $0.17/contract.

(I entered the trade on 2018-01-05 when the stock was trading @ $68.04 and exited 7 days later with the shares @ $73.91.)

Even factoring in commissions, I was able to lock in about 75-80% of the trade's maximum potential gains in only one-third of the original expected holding period (3 weeks in this case).

That's a trade off I'm going to take every time because it frees up my capital early to go out and get busy again.

Time Decay vs. Time Decay + Rising Share Price

Let's drill down a bit.

To review, I originally sold the XLNX $67.50 put for $1.25/contract, or $117.28 after commissions.

SCENARIO #1 - TIME DECAY ONLY

The original terms of the trade, projected over the 21 days until expiration, would work out to be a 30.20% annualized ROI on $6750 in cash-secured capital.

On an "income per day" basis, that's about $5.59/day.

Those were the "time decay" terms of the trade - what the trade would've produced had the underlying stock simply traded flat over the three week holding period.

Note - just to make sure we're clear, an option's theta, or the rate at which an option's time value decays, is not a constant rate but is lower the farther away that option is from expiration, and accelerates the nearer it gets to expiration.

But what about the actual results of the trade?

How did the rising share price and the accelerated decline in the value of the short put impact the trade?

SCENARIO #2 - TIME DECAY + RISING SHARE PRICE

After commissions, and buying back the $67.50 short put for $0.17/contract one week into what was originally a three week trade, I booked $92.56 on that same $6750 cash-secured capital.

Yes, I booked less total income, but because I did it in only one-third of the original expected holding period, the annualized ROI jumped all the way to 71.50%.

But what's most telling is that "income per day" figure.

On that basis, the trade resulted in daily average returns of $13.22.

The Power of Limited Downside Situations

Inside the Leveraged Investing Club, we look for what I call Limited Downside Situations when selling puts - ideally, we want to be able to point to multiple reasons why a stock is unlikely to trade lower, or lower by much, in the near term.

When we get that right - and we do have specific criteria we look at when setting up our trades - then by definition, one of two things happens:

The stock doesn't go down and we benefit from regular time decay so that the original terms of our trades are our final results
The stock trades higher and we benefit from both time decay and a rising share price so that our final results are significantly better than the trade's original terms

That's what I call Win-Win.

And if you like that, you'll love what I call Win-Win-Win-Win (i.e. how there are only four different things that can happen when we initiate one of our customized put selling based Sleep at Night trades, and how we almost always make money at the end of the day regardless of which scneario plays out).

What About Declining Implied Volatility Levels?

Finally, just to be thorough here, let's take a quick look at the implied volatility (IV) factor.

At the outset of this article, I said that the two most important factors in how a put option loses value were the passage of time (the theta or time decay factor) and a rising share price.

Changing IV levels also has an impact so I don't want to ignore it.

But it can also be a bit of a wildcard.

It basically measures the degree to which Mr. Market is pricing in uncertainty into a stock's options. That's why the option pricing is higher when their expiration cycle includes a scheduled earnings release.

It can also fluctuate along with the broader market, and in that regard, it's not a factor that we can easily predict or depend upon - implied volatility can increase just as easily as it can decrease.

But here's where our double-whammy of a rising share price (passage of time value + rising stock) often becomes something of a triple-whammy.

Because - in general, unless unusual circumstances are involved - when a stock rises, its option's implied volatility levels tend to decrease (in the same way that you'll usually see IV spike when a stock sells off).

IV isn't just about uncertainty. It's also about fear.

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