Why naked puts have less risk if used appropriately

I got an interesting question regarding the naked put strategy as follows. 

@深山老林 really it's all about risk, return and timing. although little it might seems, there is still a chance for a market melt down or MSFT reporting a terrible/underperformed quarter in the upcoming week. If the stock price takes a more than 10% dip at that time, it won't look much appearling from the 5% premium you got from shorting the put @50. At that time, if you take the covered call strategy, you could be caught in deep touble if the market behaves like that in 2008. But I agree that your strategy works in a bullish or range-bound market. The return all depends on the trend of this stock, the 'win-win' situation is not guaranteed. 

 

Here is my response. As a general caution, I totally agree with the above note on the potential risk with this strategy and therefore I’d like to emphasize again that naked puts are not a strategy for anything but only good for quality stocks at good valuation! Having said that, what stocks to get naked puts is all depending on one’s valuation  and risk/benefit assessment, position size and overall investment strategy for the stocks. A few things to consider: 1) while panic selling may bring down anything, quality and cheap stocks will usually bounce back more quickly than others 2) during a market turmoil, people often go to value stocks as safe heaven. This can clearly be seen via how WMT and MCD greatly outperformed SP during the 2008/09 crash. 3) holding a value stock at a good price will hardly go wrong over a long term period, regardless how much fluctuations its price may have, as long as the underlying business is still sound and continuing. Actually lower prices will greatly benefit us, not hurt us and can make us very rich if you can hold it for long and have its dividends reinvested. See my blog here that I can mathematically prove why lower prices are good for DRIP investment. Do I think MSFT’s dividend will be in danger just because of the market turmoil or a few missteps along the way? I’ll never say 100% not but the chance is virtually none/zero as far as I can see, given how much free cash flow it can generate and how much cash it is holding. Financially MSFT is actually much safer than the Treasury bond (considered the safest heaven) and I can trust it as a “safe bank” to pay me (increasing) dividends as long as it can continue with the current business model and development. 4) then I can use covered calls to continue generate additional incomes regardless how its price fluctuates. Don’t forget, with good technical analysis, I may go with the deep in the money covered calls to protect the potential paper loss from its market price decline if I see it is overbought or may face short-term challenges due to other reasons etc. 5) last but not least, one should always have an exist strategy if something goes terribly wrong, e.g. using a stop loss to cut loss. Same here with this strategy.

One misconception about naked puts is that people often think this is a much risker trading strategy. It is true that it could be very risky if it is used for risky stocks and/or with high leverage. But for quality stocks with normal position size at your comfortable level, it is less risky than if you buy the underlying stock outright. Why? Obviously the risk will be proportionally less if you buy something at a discount  via naked puts (e.g. buying MSFT at $47.5) than if you buy without discount via buying the stock outright at the current price (MSFT at $50).  Obviously I’m not talking about a risk free trading/investing but rather how I see the probability of winning is in favor of me for a specific stock at a specific time.