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."
BREAKING DOWN Naked Put
A naked put option strategy stands in contrast to a covered put strategy. In a covered put, the investor keeps a short position in the underlying security for the put option. The underlying security and the puts are sold or shorted in equal quantities. A covered put works in virtually the same way as a covered call. The exception is that the underlying position is a short instead of a long position, and the option sold is a put rather than a call.
A naked put strategy is inherently risky because of the limited upside profit potential and, theoretically, a significant downside loss potential. The risk lays in that the maximum profit is only achievable if the underlying price closes merely at or above the strike price at expiration. Further increases in the cost of the underlying security will not result in any additional profit. The maximum loss is theoretically significant because the price of the underlying security can fall to zero. The higher the strike price, the higher the loss potential.
However, in more practical terms, the seller of the options will likely repurchase them well before the price of the underlying security falls too far below the strike price, based on their risk tolerance and stop-loss settings.
Using Naked Puts
As a result 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, the options seller will incur a loss of $5 per share of stock.
The premium collected does somewhat offset the loss on the stock, but the potential for loss can still be substantial. The breakeven point for a naked put option is the strike price minus the premium, giving the options seller a little leeway.