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 also referred to as an "uncovered put" or a "short put." The primary use of this strategy is to capture option 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.

Key Takeaways

  • A naked put is an option strategy that involves selling put options.
  • When put options are sold, the seller benefits as the underlying security goes up in price.
  • Naked refers to an uncovered position, meaning one that has no underlying security associated with it.
  • The risk of a naked put position is that if the price of the underlying security falls, then the option seller may have to buy the stock away from the put-option buyer at a substantial loss based on the strike price the buyer is allowed to sell from.

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 to begin with.

A seller of put options wants the underlying security to rise, so that they end up profiting. But if the price of the underlying security falls, they may end up having to buy the stock, because the option buyer may decide to exercise their right to sell someone the security. Traders who like this strategy prefer only to do this on underlying securities that they view favorably. If they get the stock put to them, then, if it is a stock they like and see prospects for, they will not mind buying the stock and holding it for a least a month.

As mentioned previously, 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 respectively shorted and sold in equal quantities. When executed this way a covered put works in virtually the same way as a covered call strategy, with the primary difference being that the individual executing the covered put strategy expects to profit from the mildly declining price of a security, where a covered call expects to profit from a mildly rising price. That is because the underlying position for covered puts 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.