Naked Put

A naked put (NP) is a bullish options strategy wherein the investor writes (sells) a put option without having a short position on the underlying stock. Investors profit from the option premium fee paid by the put option buyer. The put option strategy succeeds when the underlying stock rate surpasses the strike price on or before expiration. 

Also referred to as uncovered or short put, this strategy is based on investors correctly predicting an upward swing in the underlying stock price. While an NP seller benefits from increased stock rates, the buyer cashes in on reduced prices. The maximum feasible profit is the received premium amount, while the highest possible loss is the strike price. So, unlike naked call, writing naked put involves limited losses.

• A naked put is an options trading method wherein the investor sells a put option without owning a short position in the underlying stock. 
• The naked put provides the premium amount received as maximum prospective profit and strike price as the highest possible loss. 
• A naked put seller acquires profits when the price of the underlying stock increases, while the buyer benefits from a stock price reduction. 
• At the breakeven point, the stock price equals the strike price minus the premium received. 

A put is an options contract permitting the buyer to sell, without compulsion, the underlying stock at the designated strike price within the expiration date. An uncovered put occurs when the writer sells the put option without necessary funds or a short position to cover the contract if the buyer exercises the option. 

Investors use the strategy to earn the put option premium. The writer of the NP option expects a surge in the stock price in the near future. When the stock prices are rising, buyers will not find it profitable to sell the underlying stock to the writer at a lower strike price. And, therefore, will not execute the options contract.

In such an event, the writer of the NP option will benefit. His gain will equal the amount of premium the buyer gave him while buying the put option. However, the writer will have to bear a loss if the price of the underlying security falls below the strike price.

In this scenario, the put option buyer will exercise his right to sell the stock to profit from the higher strike price. To execute the contract, the writer must buy the stocks from the buyer. For this, the writer must have enough funds or hold a short equity position.

Investors with sufficient money to acquire the short equity position consider selling naked puts less risky than holding the underlying stock. However, selling the NP option is riskier for investors with insufficient capital.

An account with ample cash flow to cover the contract can still be deemed naked if approved for an NP. Accordingly, the NP has much-reduced money requirements while the investor can dispose of the finances into other ventures. 

Most investors consider selling NPs and additional options contracts like put spreads to decrease the risk prospects. However, this contradicts a covered put where the investor owns adequate funds to purchase the underlying asset. 

Maximum Possible Profit & Loss

The highest potential gain from selling uncovered puts is the amount obtained as a premium. The NP strategy strives for worthless option expiration, providing the whole premium as profit to the investor. Maximum gain is achieved when the stock price is greater than the strike price of the NP.

The greatest prospective loss on an uncovered put is the strike price. In the rare event of the stock rate going down to $0, the investor must buy it at the strike price. Therefore, writing uncovered puts involve limited losses since the worst possible outcome is a stock’s value reducing to zero.

So NPs have a finite loss potential, as against naked calls that can lead to unlimited losses, especially to an investor writing many naked calls simultaneously.

Naked Put Margin Requirements

The margin requirements for an uncovered put are more rigid than the covered puts. It is the greater of the three:

• 100% of the option proceeds + 20% of the underlying market value – Out-of-the-money amount 
• 100% of the option proceeds + (10% of the Strike Price * Contracts * Multiplier)
• 100% of the option proceeds + $100 per contract

Let’s assume that stock XYZ is trading at $50 per share. The NP seller named Aron believes it will either remain the same or surpass the amount. So, he checks out the available options and sells the naked put option for a premium of $5 to Jane at the strike price of $55 and expiration of one month. Jane bought the put option expecting the stock price to fall.

Options trading occurs in 100 shares. So, Aron has earned a premium of $500 ($5*100).  Now, there are three possibilities:

#1 - Stock XYZ soars to $70

This signifies the worthless expiration of the put option, which offers Aron the full premium of $500. It is because Jane is not likely to sell shares to Aron at a lower price of $55 when she has the option to make a profit by selling it in the open market at $70. So here, Jane’s loss is $500 she paid as a premium to Aron.

#2 - Stock XYZ diminishes to $45

In this case, Aron must arrange the funds for purchasing the underlying security from Jane and bear the loss arising from it.

Strike price to be paid to Jane - $5500 ($55*100)

Premium received - $500

If he sells the security in the market at $45, he’ll get:

Current market value of the stocks - $4500 ($45*100)

Aron’s Loss = Strike price to be paid to Jane - Premium received - Current market value = $5500 - $500 -$4500 = $500

Jane’s Gain = Strike price received - Premium paid - Current market value = $5500 - $500 -$4500 = $500

Jane sold shares worth $4500 for $5500 after paying Aron a premium of $500. Here, Aron's loss is equal to Jane's gain.

#3 - Stock XYZ stays at $50

It also implies worthless expiration providing Aron the entire premium amount of $500. So Jane stands losing $500 paid as a premium.

A naked put option strategy lets the investor sell a put option without owning a short position in the underlying security. Only professional investors with a strong sixth sense must involve in the high-risk approach. It entails selling any single put option, ITM (In-the-money) or OTM (Out-of-the-money). 

If the underlying security’s rate outpaces the strike price by the end of the expiration date, the investor gets the full premium amount. 

Nonetheless, the investor suffers a major loss if the stock price falls below the strike price until the expiration date. In that case, the NP buyer may ask the writer to purchase the underlying stock.

Note that a breakeven point for the NP option refers to the deduction of received upfront premium from the strike price, i.e., 

Breakeven point = Strike Price – Premium Received

Stock price closing at a breakeven point helps the NP seller balance the related trading losses.

This has been a guide to Naked Put & its Definition. We explain the naked put options trading strategy, along with its uses, examples, graphs, & calculations. You can learn more from the following articles –

• Naked Shorting
• Credit Default Swap
• Short Squeeze