Definition
A Naked Put, also known as an uncovered put, is an options strategy in which an investor writes or sells put options without owning the underlying security. It’s considered risky because the investor accepts the obligation to buy the asset at a predetermined price if the option is exercised by the buyer. This means potential losses are significant if the price of the underlying asset falls drastically.
Key Takeaways
- A Naked Put, also known as an uncovered put, is an options strategy where an investor writes (sells) put options without possessing any position in the underlying security. This is a risky strategy as it exposes the investor to potential losses if the price of the underlying security falls.
- This strategy is typically used when an investor is bullish on the underlying security. The investor sells the put options with the hope that they’ll expire worthless, allowing the investor to pocket the entire premium received from selling the options.
- However, if the price of the underlying security drops below the strike price before the options expire, the investor will be obligated to buy the security at the strike price. If the price drops significantly, this can result in substantial losses. Therefore, it’s important for investors using this strategy to be prepared to buy the underlying security or to manage the position to limit losses.
Importance
The finance term “Naked Put” is important because it refers to an options strategy where an investor sells put options without holding an adequate position in the underlying security.
This practice is also known as “writing naked puts.” The strategy boasts potentially significant profits via the collection of premiums from the sale of the put options, which the seller gets to keep if the options expire out-of-the-money.
However, it is also a highly risky strategy, as sellers of naked puts are exposed to the possibility of substantial losses if the price of the underlying security drops significantly and they are required to buy the underlying asset at the strike price, which would be significantly higher than the market price.
Therefore, it’s a strategy used mainly by advanced or institutional investors.
Explanation
The term ‘Naked Put’ refers to an options strategy wherein an investor sells, or writes, put options without having the security or the cash to cover the contractual obligation. The primary purpose of a naked put strategy is to generate income through the collection of premiums from the sale of the put options.
Investors who use this strategy believe that the price of the underlying security will stay the same or increase over the life of the option. Applying a naked put strategy allows investors to potentially purchase the underlying security at a lower price while collecting premiums through the sold options.
However, it comes with substantial risk, primarily because if the security’s market price falls drastically, the seller might be forced to purchase it at a price that’s much higher than the prevailing market price. As such, the naked put is typically executed by experienced investors who are bullish on the security in question.
Examples of Naked Put
A naked put, also known as an uncovered put, is an options strategy in which an investor writes (sells) put options without owning the obligated quantity of the underlying security. Below are three hypothetical yet realistic examples for a better understanding:John’s Investment:Consider an investor named John who writes a naked put option for Company A’s stock, which is currently trading at $
He sells a one-month put option with a strike price of $45 and collects a premium of $2 per share (or $200 in total as one option contract represents 100 shares). John does not own any shares of Company A. If the stock price stays above $45, he keeps the premium as his profit. If the stock price falls below $45, he is obligated to buy 100 shares per contract for $45 each, even if the market price is lower, thus carrying a large risk.Sarah’s Short-Term Profit:Sarah believes that the technology company XYZ will have stable share prices for the next six months. She writes a naked put option on 100 shares of XYZ with a strike price of $100, earning her a premium of $
If XYZ’s price stays above $100, she keeps the whole premium as her profit. If the price dips, she is forced to buy 100 shares for $100 each, with the risk of losing money if she resells them at their lower market value.Paul’s High-Risk Trade: Paul, an experienced investor, decides to write naked put options for stocks he wouldn’t mind owning if the market price dips below the strike price. He arranges a deal for 100 shares of ABC Corporation with a strike price of $60 per share and receives a $700 premium from this. If the stock price stays above the strike price, he makes $
Otherwise, he will buy ABC Corporation’s shares for $60 a piece, regardless of the current market price. The potential upside is limited to the premium received, and the downside risk is substantial.
“`
Naked Put FAQs
What is a Naked Put?
A Naked Put, also known as an Uncovered Put, is a put option whose writer (the person selling the put option) does not have a short position in the underlying stock. This is a risky strategy as the seller is exposed to potentially significant loss if the market moves unfavorably.
What are the risks associated with Naked Puts?
Since the seller does not own the underlying stock, the potential loss can be substantial if the market moves in an unfavorable direction. The maximum loss can be as large as the strike price of the put option (multiplied by the number of shares), less the premium received from selling the option.
Who typically uses Naked Puts?
A Naked Put is usually employed by advanced traders who are comfortable with the risks and rewards associated with this strategy. It can offer significant profit potential if the market conditions are suitable and the trader’s market outlook is accurate.
How is profit calculated in Naked Puts?
The maximum profit in a Naked Put strategy is the premium received from the sale of the put option. This is achieved if the price of the underlying stock is at or above the strike price at expiration. Therefore, the profit equals the premium received less any commissions.
“`
Related Entrepreneurship Terms
- Naked Options
- Option Premium
- Strike Price
- Moneyness
- Option Expiration
Sources for More Information
- Investopedia: A comprehensive educational site about finance with a detailed section on derivatives, including Naked Puts.
- Nasdaq: The site of the NASDAQ stock exchange, which provides various educational resources about options trading, including Naked Puts.
- Fidelity: A large financial services company that provides educational resources on topics related to investment, including options like Naked Puts.
- Charles Schwab: Another financial services company that provides informative articles and guides about different aspects of trading, including Naked Puts strategies.
