Why o many put investors will willingly pay outlandish prices to buy the very deep out-of-the-moneys
The JCP Jan. 10-strike puts are currently quoted at $34 bid, $38 asked. Why would anyone in his right mind be willing to pay such prices when the 10-year low on the stock is $13.55 and the company has real estate that was recently appraised as being worth $18 per share? Does anyone really think they need protection below ten bucks a share for this company?
Well, protection is NOT the reason why these options which should be almost worthless are so richly priced. The reason for the crazy price has to do with BULLISH JCP investors who want to reap the rewards of selling somethin like the Jan. 15-strike puts but who want to drastically lower their margin requirements.
It's a fac t that 98 to 99% of put sellers sell them fully cash-covered because they do not have the authorization to sell thme naked. Brokerage firms were badly stund by unsuitability lawsuits during the crash and they are granting very few new authorizations to sell naked puts.
Margin requirements are quite onerous for fully cash-covered put sellers as the assumption always has to be made for margin purposes that the company will go completely bust. So for sellers of a 15-strike JCP put out to January, the margin requirement is a full $1,500 per contract. Net proceeds are $144 for 7.4 months and so the return would be 9.6% for that periiod.
But a fully cash-covered put seller can do MUCH better than that by simply BUYING something like the 10-strikes for January. Yes - he will pay $39 per contract after commissions and that will lower his potential profits to $105 per unit instead of the $144 per contract that were possibly without the purchase of the lower strike. But by buying that lower strike, the fully cash-covered put investor lowers his margin requirements from $1,500 per contract all the way down to $500 per unit. That's because the risk is only now from $15 to $10 on the stock instead of from $15 to zero.
The return if the stock holds above $15 (it's $18.73 now) would balloon to 21.0% for 7.4 months instead of just 9.6% for the period if the investor didn't take the necessary steps to lower his margin requirement.,
Now the options market makers are aware that there is this need for most put investors to buy these deep out-of-the-moneys and it's the market makers that end up selling most of the contracts to these buyers. They of course want top dollar for their sales and so they will jack up the prices to "whatever the traffic will bear." As it turns out, the traffic will bear a LOT. Because absolutely the ONLY way that fully cash-covered put sellers can lower their margin requirements is to also buy the deep out-of-the-moneys when they are selling the closer-to-the-money contracts.
So then comes along someone like me with NAKED put authorization at the lowest margin outfit in the land, TD Ameritrade. MY margin requirements aren't anything like $1,500 per contract or even $500 per contract. For 10-strike naked puts with an ask of $38, my margin requirement is a mere $138 per contract and I will receive about $33.40 per contract after commissions. So MY return if held to expiration will be 24.2% for 7.4 months and all that I need with my sale of the 10-strikes is for the stock to hold above the margin-safe price of $11.25. With an expected early-out, my return will likely be on the order of 4% per MONTH. And this for selling 10--strike naked puts with the stock at $18.73, with the 10-year low being $13.55 and with the company owning underlying real eastate worth $18 per share.
The return mentioned above, however, is available ONLY at Ameritrade because at no other brokerage in the nation will you see the margin requirement per contract anywhere near as low as $138. Each brokerage has the right to set its own margin requirements for naked puts and only Ameritrade really wants this business.