What is a Naked Put?
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. A naked put strategy is sometimes referred to as an “uncovered put” or a “short put” and the seller of an uncovered put is known as a naked writer.
The primary use of this strategy is to capture the option’s premium on an underlying security forecast as going higher, but one which the trader or investor would not be disappointed to own for at least a month or maybe longer.
The Naked Put Strategy
The naked put strategy involves an investor selling a put option without:
- Already having, or establishing at the time of selling the option, an equivalent short position in the underlying security; or
- Having the necessary funds in their investment account to cover the cost of establishing an equivalent amount of short position in the underlying security in the event that the option is exercised.
If the conditions of either scenario above are met, then the put option the investor sells is not considered a naked put, but instead, a “covered” or “secured” put. If the conditions of scenario B, but not of scenario A, are met, then the put option sold is referred to as being “cash-secured.”
A put that an investor sells may be either naked, covered, or partially covered. The put option is said to be partially covered if the investor selling the put has a short position in the underlying security, but not one large enough to represent an amount equivalent to the amount represented by the put option they are selling.
How a Naked Put Works
A naked put option strategy assumes that the underlying security will fluctuate in value, but generally rise over the next month or so. Based on this assumption, a trader executes the strategy by selling a put option with no corresponding short position in their account.
This sold option is said to be uncovered because the initiator has no position with which to fill the terms of the option contract, should a buyer wish to exercise their right to the option.
Since a put option is designed to create profit for a trader who correctly forecasts that the price of the security will fall, the naked put strategy is of no consequence if the price of the security actually goes up. Under this scenario, the value of the put option goes to zero and the seller of the option gets to keep the money they received when they sold the option.
Maximum Profit and Loss from Selling a Naked Put
The seller of a put option is an investor who believes that the underlying security’s price will not decline to any point below the strike price of the option before expiration. If they are correct, then the option they sell will expire as worthless, and they will realize the maximum potential profit – the amount of the premium they receive for selling the option. The “premium” is the purchase price of the option.
The maximum potential loss for the seller of a naked put option is the strike price of the option times 100 shares, minus the premium received for selling the put. So, if an option seller sold a naked put with a strike price of $45 and the price of the underlying security went to $0, then their loss would be $4,500 ($45 times 100 shares), minus the amount of the premium they received.
In any event, the naked put seller’s profit/loss is equal to the premium received, minus any loss incurred from the option being exercised.
Using Naked Puts
Because of the risk involved, only experienced options investors should write naked puts. The margin requirements are often quite high for this strategy as well, due to the propensity for substantial losses.
Investors who firmly believe the price of the underlying security, usually a stock, will rise or stay the same may write put options to earn the premium. If the stock persists above the strike price between the time of writing the options and their expiration date, then the options writer keeps the entire premium, minus commissions.
When the price of the stock falls below the strike price before or by the expiration date, the buyer of the options vehicle can demand the seller take delivery of shares of the underlying stock. The options seller will then have to go to the open market and sell those shares at the market price loss, even though the options writer had to pay the options strike price.
For example, imagine the strike price is $60, and the open market price for the stock is $55 at the time the options contract is exercised. In this case, the options seller will incur a loss of $5 per share of stock.