A naked put is an options strategy in which the investor writes, or sells, put options without holding a short position in the underlying security. Also known as an “uncovered put” or a “short put,” the seller of an uncovered put is often referred to as a naked writer.
The primary goal of this strategy is to capture the option’s premium when an underlying security is forecast to rise. This is particularly appealing to traders or investors who are not averse to potentially owning the underlying asset for a longer period, such as a month or more.
Key Takeaways
- A naked put occurs when a put option is sold without any offsetting positions.
- The seller benefits as the price of the underlying security increases.
- The maximum profit is limited while theoretically, the downside loss potential exists from the current price down to zero.
- The breakeven point for the seller is the strike price plus the premium received.
How a Naked Put Works
The naked put strategy is predicated on the assumption that the underlying security will generally increase in value over the next month or so. A trader executes this strategy by selling a put option without holding any corresponding short position. This sold option is considered “uncovered” because the seller has no pre-existing position suitable for fulfilling the terms of the option contract if the buyer exercises their right.
Since a put option is designed to generate profit for a trader who anticipates a decline in the security’s price, the naked put strategy profits when the price of the security increases. If the value of the security goes up, the value of the put option decreases to zero, allowing the seller to retain the premium received upon selling the option.
Sellers of put options desire the underlying security to appreciate so they end up profiting. However, if the security’s price falls, they may need to buy the stock since the option buyer has the right to sell the stock at the option’s strike price. Traders successful with naked puts often choose securities they deem favorable and would be willing to own in the long run.
Naked Put vs. Covered Put
A naked put strategy contrasts with a covered put strategy. In a covered put, the investor holds a short position in the underlying security for the put option. Thus, the underlying security is shorted and the puts are sold in equivalent quantities.
When done this way, a covered put works similarly to a covered call strategy. The primary distinction is that the executor of a covered put expects to profit from a slightly declining price of the security, whereas a covered call trader anticipates profit from a mildly rising price. The basis for a covered put is a short position and the selling of put options, as opposed to a long position and call options in a covered call strategy.
Special Considerations
A naked put strategy is risky due to its limited upside profit potential and significant downside loss potential. Maximum profit is only achievable if the underlying price closes at or above the strike price at expiration. Any further increase in the security’s cost won’t yield additional profit.
However, the potential for loss is theoretically significant as the price can drop to zero. The higher the strike price, the greater the potential loss. In practice, many options sellers will repurchase the options to avoid substantial losses well before the underlying security’s price falls too far from the strike price, guided by their risk tolerance and stop-loss settings.
Using Naked Puts
Given the inherent risks, only seasoned options investors should engage in writing naked puts. Margin requirements are typically high for this strategy due to the potential for considerable losses.
Investors who are confident that the underlying security’s price (usually stocks) will rise or remain stable may write put options to earn the premium. If the stock hovers above the strike price from the time the options are written until their expiration, the options writer retains the premium, minus any commissions.
But, when the stock price dips below the strike price by the expiration date, the options buyer can demand the seller to fulfill the contract, meaning the seller must go to the open market, buy the shares, and sell them at a market loss. For instance, if the strike price is $60 and the market price is $55 when the option is exercised, the seller incurs a $5 per share loss.
While the collected premium might offset some losses, the overall potential for loss remains substantial. The breakeven point for a naked put option is the strike price minus the premium, providing the options seller some margin.
Related Terms: put options, short position, covered calls, strike price, margin requirements.
