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April 23, 2010
Uncovered Puts
Uncovered puts can but a very profitable and effective way to trade options. Traders engage in selling puts when technical analysis and fundamental analysis of the equity market in general and the underlying equity in particular will be stable for the course of the options contracts. Selling puts places an obligation on the seller to sell the underlying if the buyer so chooses. This is unlike buying puts or buying calls where the buyer has the option but not the obligation to buy or sell. Uncovered options trading is when the trader does not own the underlying equity to begin with. In the case of uncovered puts the trader believes that stocks, commodities, or futures will not vary in price or will go up in price. Thus the buyer will not choose to sell the equity. The seller of uncovered puts gains the premium paid and goes on to the next trade.

Trading uncovered puts and uncovered calls are, over time, the more profitable
option trading strategies. The investment is less than in covered options trading and over many trades the profit is greater. The downside to uncovered puts is when the equity does not stay put but falls dramatically in value. Then the trader may be obligated to buy a stock or commodity at the much higher strike price when the spot price, the now current market price, is substantially lower. In this case the trader stands to lose substantially on the trade unless he or she is willing to hold on to the underlying equity and it does, in fact, regain its value. Thus, selling puts, as well as selling calls, is typically the business of large institutional investors with the financial reserves to weather the occasional large loss in the options markets.

The
technical analysis tools used to assure the trader that a stock price will stay put or go up are the same used to predict market reversal or equity movement in trend trading. Candlestick analysis tools such as Candlestick chart formations have helped traders for centuries in using market data to predict the market’s next move. In the case of selling uncovered puts the trader wants to know that the equity underlying the option contract is not going to go down in price. It is OK if the equity stays the same or goes up as the buyer of a put will not exercise the option unless the price drops. An instance in which the trader wants to know that the price will not move at is when he or she engages in an options trading strategy known as a short straddle. In this case the trader sells both a call and a put. This strategy doubles the premium income but also increases the risk.

As in all trading there is
investment risk in trading uncovered puts. What is essential to make this strategy effective is a broad, fundamental knowledge of the underlying equity coupled with astute evaluation of technical indicators to assure that the equity in question is not going to go down in price. As in all trading you will need to keep track of your trades or place limit orders to guard against loss.

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