A naked put is an options trading strategy where an investor sells a put option contract without owning the underlying security. It involves taking on the obligation to buy the underlying asset at a predetermined price, which is called the strike price, if the option is exercised by the option buyer. The term “naked” indicates that the seller does not hold a corresponding short position in the underlying asset to hedge against potential losses. Here’s what traders need to know.
A financial advisor can walk you through different investment options for your portfolio.
How a Naked Put Works
When using a naked put strategy, the seller receives a premium from the buyer upfront for selling the put option. If the price of the underlying asset remains above the strike price until the option’s expiration, the option expires worthless, and the seller keeps the premium as profit.
However, if the price of the underlying asset drops below the strike price, the option buyer may choose to exercise the option. In this case, the seller of the naked put is obligated to buy the underlying asset at the strike price, regardless of the market price.
You should take note that naked put writing carries substantial risk because the potential losses are potentially large if the price of the underlying asset experiences a significant decline.
As a result, many brokers impose strict requirements and risk management measures for traders engaging in naked put writing.
Naked Put vs. Covered Put
Naked put and covered put are two distinct options trading strategies that involve put options. Here’s a comparison between the two:
- Position. A naked put involves selling a put option contract without having a short position, so the trader takes on the obligation to potentially buy the underlying asset at the strike price if the option is exercised by the option buyer. A covered put, on the other hand, involves selling a put option contract while simultaneously holding a short position in the underlying security. In this case, the trader already has a short position in the underlying asset that he or she may potentially have to buy if the option is exercised.
- Risk exposure: A naked put carries higher risk due to the lack of an underlying asset as a hedge, potentially resulting in large losses. But a covered put carries lower risk as the trader holds the underlying asset, providing a degree of protection against significant losses.
- Market outlook: While a naked put is used when the trader is bullish or neutral on the asset, a covered put is used when the trader is bearish on the asset and wants to protect against potential losses.
- Profit potential: The profit potential in both strategies is limited to the premium received from selling the put option. There is potentially some additional gain on a covered put if the short price is different from the strike. For example, suppose the seller shorted at $100, but the strike is $99. The covered put writer can gain $1 plus the put premium.
- Risk management: Both strategies require careful risk management and an understanding of the potential outcomes. Traders should carefully assess their market outlook, risk tolerance, and desired level of protection when deciding between a naked put and a covered put strategy.
When a Naked Put Strategy Is Used in Options Trading
Traders typically use a naked put strategy for these common reasons under certain market conditions:
- Income generation: Traders use a naked put strategy to generate income through the premium received from selling the put option. If the option expires worthless (not exercised), the trader keeps the premium as profit.
- Bullish outlook: A trader who believes that the price of the underlying asset will remain stable or increase may opt for a naked put strategy. This strategy allows them to benefit from bullish or neutral market expectations.
- Risk tolerance: Traders with a higher risk tolerance may consider a naked put strategy to potentially earn higher premiums. However, they must be prepared for the possibility of significant losses if the market moves against them.
- Uncertainty: When traders are uncertain about the immediate market direction but don’t anticipate significant downside, they might choose a naked put strategy to take advantage of the premium while maintaining flexibility.
- Margin efficiency: Some traders use a naked put strategy to make use of margin requirements more efficiently. The premium received can offset the margin required, potentially freeing up capital for other trades.
- Options writing: Traders who are experienced in options writing may use a naked put strategy as part of a diversified options trading approach.
It’s important to note that a naked put strategy carries substantial risk due to potential large losses if the underlying asset’s price significantly declines. Traders should have a clear understanding of options, risk management strategies and market trends before implementing this strategy. Additionally, some brokerage platforms have specific requirements or restrictions for traders using a naked put strategy, such as minimum account balances or margin requirements.
Tips for Investors
- A financial advisor could help you figure out if a naked put option could work for your investing needs. Finding a financial advisor doesn’t have to be hard. SmartAsset’s free tool matches you with up to three vetted financial advisors who serve your area, and you can have a free introductory call with your advisor matches to decide which one you feel is right for you. If you’re ready to find an advisor who can help you achieve your financial goals, get started now.
- As an investor, you may also consider call options. A call option allows investors to buy stocks, bonds, commodities or other securities at a certain price and within a specific time frame. If the price of your investment increases, your gains could multiply. However, if the price drops, you could lose money.
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