No Nudes Is Good News

While the losses are limited, the potential gains aren't. Stocks and bonds are worth whatever someone is willing to pay. So when you buy XYZ, there's no telling how high it might fly.

The other basic method of making money, however, is what I call the insurance format, an approach best exemplified by the options-writing strategies that have become increasingly popular with individual investors. In this case, a person is paid essentially to assume the risk of ownership without actually owning the security in question. The upside is limited, but the loss isn't.

An option is the right, but not the obligation, to buy or sell a specific security at a specific price — the strike price — anytime before a specific expiration date. When you buy an option, you pay a fee, known as a premium, to the seller of the option. Option sellers are also called writers. (For more on options visit SmartMoney.com's Options Center).

Although the premium is generally small relative to the risk of owning the stock, it's the promise of being able to collect them over and over again that cements this strategy's appeal to option writers. And while the approach might sound intriguing in the abstract, I firmly believe that speculatively writing options to collect a premium is a strategy most individual investors should avoid. For me, it never seems to work out.

Let's take the naked put, for example, a trade that immediately appeals to most investors because of its seductive promise of a cash payout upfront. When you sell a naked put — naked refers to the fact that the option writer doesn't have an offsetting position in the underlying shares — say the XYZ September $50 put, you're obligated at the request of the option holder to buy 100 shares of XYZ at $50 per share anytime before the close of business on the third Friday in September. In exchange for taking this risk, you receive a premium. If XYZ's stock is trading at $53 a share, then the premium might be $1 a share, or $100 total (a standard equity option contract represents 100 shares of the underlying stock).

The appeal is obvious: Selling a put nets you immediate cash, in this case $100. And with a naked put, as opposed to a covered put, there's no extra expense involved in establishing offsetting positions, such as shorting the underlying stock. It seems almost like magic. You make a trade and all of a sudden there's more money sitting in your account, not less.

You, as the option writer, of course hope that the stock stays above $50. If it does the option will expire worthless because the option holder certainly doesn't want to sell you shares of XYZ at a below-market price. Best of all, you keep the $100 premium free and clear. However — and this is a big however — if XYZ drops to say $45 a share, then you're forced to purchase the stock at the above-market strike price of $50 a share. You could also buy back the put at a loss, an equally unappealing proposition (more on this below).

Now do you see why I avoid selling naked puts? Despite the allure of the upfront premium, the strategy subjects you to 100% of the risk with only a tiny fraction of the upside potential. No matter how far XYZ drops, you'd still be obligated to buy it at $50 a share. And regardless of how high it went, the most you'd make on the trade was the $100 premium you were originally paid.