A naked put option, also known as an “uncovered put,” is a risky options strategy in which a trader writes (i.e. sells) a put option with no corresponding short position in the underlying asset. While this strategy allows the trader to collect the option premium up front, in hopes that the underlying asset will rise in value, it carries significant downside loss potential should the price of the underlying asset decline.
Here’s what you need to know about naked put options:
Understanding Naked Put Options
As a refresher, the buyer of a put option has the right, but not the obligation, to sell an underlying security at a specific price. On the flip side, the seller of a put option is obliged to purchase the underlying asset at the strike price if and when the option buyer chooses to exercise.
Writing a naked put means that the trader is betting that the underlying security will rise in value or hold steady. If, at the option’s expiration date, the price of the underlying security is above the strike price, the options contract will expire worthless, allowing the seller to keep the premium. The potential profit of the trade is capped at the initial premium collected.
The risk of a naked put option trade is that the potential losses can be much greater than the premium initially gained. If the price of the underlying security declines below the strike price, the option seller can be forced to take assignment of shares in the underlying security. The options seller would then have to either hold those shares, or sell them in the open market at a loss (since they were obligated to purchase them at the strike price).
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Requirements for Trading Naked Put Options
Investors have to clear some hurdles before being able to engage in a naked put transaction.
Typically, that begins with getting cleared for margin trading by their broker or investment trading firm. A margin account allows an investor to be extended credit from their trading firm in order to actually sell a naked put.
There are two main requirements to be approved for a margin account in order to trade naked put options.
• The investor must demonstrate the financial assets to cover any portfolio trading losses.
• The investor must declare they understand the risks inherent when investing in derivative trading, including naked put options.
Selling Naked Puts
A trader initiates a naked put by selling (writing) a put option without an accompanying short position in the underlying asset.
From the start of the trade until the option expires, the investor keeps a close eye on the underlying security, hoping it rises in value, which would create a profit for them. If the underlying security loses value, the investor may have to buy the underlying security to cover the position, in the event that the buyer of the put option chooses to exercise.
With a naked put option, the maximum profit is limited to the premium collected up front, and is obtained if the underlying security’s price closes either at or above the option contract’s strike price at the expiration date. If the underlying security loses value, or worse, the value of the underlying security plummets to $0, the financial loss can be substantial.
In real world terms, however, the naked put options seller would see the underlying security falling in value and would likely step in and buy back the options contract in advance of any further decline in the security’s share price.
Naked Versus Covered Puts
We’ve mentioned a few times so far that in a naked put, the trader has no corresponding short position in the underlying asset. To understand why that is important, we need to talk about the difference between covered puts and naked puts.
A covered put means the put option writer has a short position in the underlying stock. As a reminder, a short position means that the investor has borrowed shares of a security and sold them on the open market, with the plan of buying them back at a lower price.
This changes the dynamics of the trade, compared with a naked (uncovered) put. If the price of the underlying security declines, losses incurred on the put option will be offset by gains on the short position. However, the risk instead is that the price of the underlying security could move significantly upward, incurring losses on the underlying short position.
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Example of a Naked Put Option
Here’s an example of how trading a naked put can work:
XYZ stock is trading at $50 per share. Alice, a qualified investor, opts to sell a put option expiring in 30 days with a strike price of $50 for a premium of $4. Typically, when trading equity options, a single contract controls 100 shares – so the total premium, her initial gain, is $400. If the price of XYZ is above $50 after 30 days, the option would expire worthless, and Alice would keep the entire $400 premium.
To look at the downside scenario, suppose the price of XYZ falls to $40. In this case, Alice would be required to buy shares in XYZ at $50 (the strike price), but the market value of those shares is only $40. She can sell them on the open market, but will incur a loss of $10 per share. Her loss on the sale is $1,000 (100 x $10), but is offset by the premium gained on the sale of the option, bringing her net loss to $600. Alternatively, Alice could choose not to sell the shares, but hold them instead, in the hope that they will appreciate in value.
There’s also a break-even point in this trade that investors should understand. Imagine that XYZ stock slides from $50 to $46 per share over the next 30 days. In this case, Alice loses $400 ($4 per share) after buying the shares at $50 and selling them at $46, which is offset by the $400 gained on the premium.
The maximum potential loss in any naked put option sale occurs if XYZ’s stock price goes to $0. In this instance, the loss would be $5,000 ($50 per share x 100 shares), offset by the $400 premium for a net loss of $4,600. Practically speaking, a trader would likely repurchase the option and close the trade before the stock falls too significantly. This can depend on a trader’s risk tolerance, and the stop-loss setting on the trade.
The big risk of a naked put option trade is that the potential losses can be much greater than the premium initially gained, while the maximum profit is limited to the premium collected up front. The seller of an uncovered put thinks the underlying asset will rise in value or hold steady.
Like most options trading strategies, the complexity of naked options trading and the associated risks make it a strategy that’s typically best for experienced traders. There are plenty of less risky ways for beginner investors to start building a portfolio. One way to do just that is by opening a brokerage account on the SoFi Invest trading platform. Using the SoFi app, you can select company stocks, exchange-traded funds and fractional shares to build your portfolio, or you can opt for the automated features which build a portfolio on your behalf.
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