A naked put refers to a situation where an investor sells a put option without already having an equivalent short position in the option’s underlying security. It is one of the ways that an investor can profit from changes in the price of a security without directly investing in the security itself.
Options offer numerous investment strategies, as they provide numerous ways to combine the buying and selling of call options and put options with different strike prices and expiration dates.
A put is a type of options contract that offers its owner or buyer the right to sell the option’s underlying asset at a predetermined strike price. With an American-style option, the option holder may choose to exercise the option to sell the underlying security at any time up until the option’s date of expiration. With a European-style option, the option to sell short the underlying security may only be exercised on the option’s expiration date.
The seller of a put option is looking to profit from the price of the underlying security staying at or above the option strike price through the option’s expiration date.
A naked put involves an investor selling a put option without holding an equivalent short sell position in the market.
The most an investor can lose from selling a naked put is the strike price multiplied by 100 shares, minus the premium received; the maximum potential profit is the premium received.
The Naked Put Strategy
The naked put strategy involves an investor selling a put option without:
1. Already having, or establishing at the time of selling the option, an equivalent short position in the underlying security; or
2. Having the necessary funds in their investment account to cover the cost of establishing an equivalent amount of short position in the underlying security in the event that the option is exercised.
If the conditions of either scenario above are met, then the put option the investor sells is not considered a naked put, but instead, a “covered” or “secured” put. If the conditions of scenario B, but not of scenario A, are met, then the put option sold is referred to as being “cash-secured.”
A put that an investor sells may be either naked, covered, or partially covered. The put option is said to be partially covered if the investor selling the put has a short position in the underlying security, but not one large enough to represent an amount equivalent to the amount represented by the put option they are selling.
Understanding the “Equivalent Amount”
So, what are we talking about when we refer to an “equivalent amount” of an option’s underlying security? An equivalent amount is an amount equal to the amount of the underlying security that is represented by the option.
For example, options on stocks are typically options to either buy (for the holder of a call option) or sell (for a put option holder) 100 shares of the underlying stock. Therefore, 100 shares of the underlying stock is the amount that is equivalent to one option contract on the stock.
If an option seller sold five options contracts, then the equivalent amount of the underlying stock would be 500 shares. If the option seller of five put options wanted to sell covered puts, then they would need to either already have sold short (since it is a put option) or sell short at the same time that they sell the put option at least 500 shares of the underlying stock.
Understanding the Strike Price
The buyer of a put option expects to profit from a decline in the price of the underlying security. For example, an investor who expects the stock of Company ABC, currently with a market price of $50, to decline in price to $25 per share, may be interested in buying a put option on the stock. The put option gives the person who buys the option the right to sell the underlying security short at the option’s designated strike price.
Options offer a variety of strike prices for an investor to choose from. For example, a stock currently selling for $50 a share may have strike prices of $60, $55, $50, $45, and $40. Since we’re talking about a put option – an option that offers its holder a profit if the underlying security falls, rather than rises, in price – the option holder profits to the extent that a decline in the underlying security’s price increases the value, or price, of their put option.
All put options on an underlying security will increase in value if the security declines in price, but that does not necessarily mean that the option holder will want to exercise the option to obtain a short position in the market. Exercising the option is only profitable if the price of the underlying security falls to a price below the strike price of the option. Continuing with the example above of a stock trading at $50 per share, let’s assume an investor buys an option on the stock with a strike price of $45.
Now, if the market price of the stock fell to $48 a share after the investor bought a put option with a $45 strike price, then the put option would increase in value (depending on the time remaining till expiration), and the investor may be able to sell their option and realize a profit.
However, it would not be profitable for them to exercise the option with the market price at $48, because establishing a short sell position at $45 would give them a $3 per share loss. It is only profitable to exercise the option if the market price of the underlying stock declines to a price below $45.
Requirements for Naked Option Trading
Selling a naked put, one that is not covered requires the seller to be approved for margin trading by their broker and thus have a margin account. A margin account enables the investor to essentially borrow from their broker the necessary funds to implement their options trading strategy of selling a naked put.
The requirements to be approved for margin trading depend on (1) the investor’s financial position, and (2) the investor’s stated investment goals and preferences. As for the latter requirement, the investor must have declared themselves as being interested in either speculative investing or day trading and also have declared themselves as having a high level of risk tolerance.
Maximum Profit and Loss from Selling a Naked Put
The seller of a put option is an investor who believes that the underlying security’s price will not decline to any point below the strike price of the option before expiration. If they are correct, then the option they sell will expire as worthless, and they will realize the maximum potential profit – the amount of the premium they receive for selling the option. The “premium” is the purchase price of the option.
The maximum potential loss for the seller of a naked put option is the strike price of the option times 100 shares, minus the premium received for selling the put. So, if an option seller sold a naked put with a strike price of $45 and the price of the underlying security went to $0, then their loss would be $4,500 ($45 times 100 shares), minus the amount of the premium they received.
In any event, the naked put seller’s profit/loss is equal to the premium received, minus any loss incurred from the option being exercised.
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