Options strategy - Shot Put

Naked Put Selling (Selling Uncovered Puts)

Investor Sentiment:
Neutral to Bullish strategy

Profit Potential:
Realize revenue if stock price stays the same or slightly increases. The put option seller realizes profit if the stock price rises and the put option expires worthless. This strategy can also be used to buy stocks at a discount (if stock drops below put strike, allow stock to be "put" to you and you keep the put premium).

Risks:
If stock price moves down significantly, the sold put option premium will increase and it will cost more to close the put position.

Drawbacks:
The naked put writer has downside loss potential should the stock price drop significantly during the option period. The only limit to the loss potential for a naked put writer is the stock price cannot drop past a zero value.

Naked Put Selling Introduction

If you review our put buying description page, you will understand that the put buyer realizes profit if the stock goes down prior to the put option expiration date. The put option buyer is anticipating that a profit can be realized when the stock price moves down and the position can then be closed. Therefore, the opposite is true for the put option seller. The seller of a put will realize profit if the underlying stock price increases.

Let's put it in simpler terms. The put buyer is anticipating that the stock price will decrease; the put seller is anticipating that the stock price will stay the same or slightly increase. The put writer (seller) has the obligation to buy the stock at the put strike price should the stock price decrease below the put option strike price. In return for this obligation, the put writer (seller) receives the put option premium. If the stock price increases during the option period, the option will expire worthless and the put writer retains the premium, and he/she is not assigned to purchase the stock at the put option strike price.

Similarities - Naked Put Selling and Covered Call Writing

The naked put selling strategy has similar risks and characteristics to writing covered calls except that the underlying stock is not owned. The put seller will realize profit if the stock price is neutral or increases during the option period by retaining the put option premium. Because we want to realize the entire put option premium as profit, the calloptionputoption.com "Sell Naked Puts" data only includes out-of-the-money data. In-the-money put sellers have a greater risk of being assigned (obligated to purchase the stock at the put strike price) than out-of-the-money put sellers. If the stock price should fall during the option period, the in-the-money put writer (seller) will lose money more quickly than the out-of-the-money put writer (seller). Similar to the ITM covered call option strategy, the in-the-money put selling position takes in a larger premium, but has less profit potential.

Referring to the noted expert:

"It is fairly easy to summarize all of this by noting that in either the naked put writing (selling) strategy or the covered call writing (selling) strategy, a less aggressive (in-the-money) position is established when the stock price is higher than the option strike price. If the stock price is below the option strike price initially, a more aggressive (out-of-the-money) position is created".

McMillan -- "Options As a Strategic Investment"

Visualize this concept on a vertical line going up and down, with a stock price of zero on the bottom of the line and an infinite price on the top end. If you have a stock price somewhere on the line, the in-the-money put strike price is above the stock price and the out-of-the-money put strike price is below the stock price.

There are also some differences between put writing (selling) and covered call writing (selling). The naked put position requires a smaller investment than required for a covered call write because the covered call position requires the investor to purchase or own the stock. The naked put writing strategy requires the investor to have a margin account with a certain level of options trading experience. The margin requirements for naked put writing are 20% of the stock price minus the put premium. This is a general rule and will vary depending on the brokerage you are using. Each brokerage also has a minimum security or equity value requirement before naked put transactions may occur. The reason that naked put selling is attractive to investors is because no capital investment is required.

Another difference is the covered call writer receives the dividends on the underlying stock, but the naked put seller does not. Even though this is an advantage to covered call writing, the initial capital outlay necessary to purchase the underlying stock makes the naked put selling strategy a better rate of return position.

Naked put positions are reviewed on a daily basis. If the stock price has increased enough, the naked put writer may get a call from his/her broker to deposit additional stock or cash or close the naked put position. The brokerage must ensure that the investor has enough funds to cover the position should the stock price drop and the naked put writer will have to close his/her put option position at a higher put premium than was originally retained when selling the put position.