What is a Naked Put?
A naked put refers to selling a put option without having a postion in the underlying security . A naked put, which is not part of another options strategy, is sold for one of two reasons. The first reason is truly for purposes of speculation; when the market is climbing higher, the seller of a naked put believes that the stock will remain above the strike price of the option at the expiration date. If that holds true, the seller of the put will pocket the entire premium that was paid by the buyer for the downside protection.
Secondly, selling naked puts is another way for a bullish trader to buy a stock at a discount. For example, suppose that Goldman & Sachs (GS) is currently trading at $100 per share. The trader may sell a $100 put and receive $7 per share for it. If the stock is trading below $100 at expiration, the put writer will be put into the stock at $100; therefore, the trader's net cost to put the trade on is $100 - $7, or $93
From a speculators viewpoint, selling naked puts is a common strategy to trade low volatility stocks by selling puts that are out of the money. This way, if the security stays around the same price or higher, the put will expire worthless and the seller will keep all of the premium. Conversely, if the security begins to lose value, the put premium would increase, thus increasing the amount owed by the put seller. To protect against the downside risk of the stock, the put writer may sell the underlying security short once the underlying drops below the strike price of the put in order to hedge against the losses that would have been incurred on the short put position.
Naked Put Risk Characteristics
Notice, the naked put is a limited gain, unlimited risk strategy. The peak profit occurs when the stock expires above the strike price above the put at expiration. Remember, you are selling another trader protection, or basically providing insurance against the downside for a premium so there is really nothing more to gain from this trade.
Conversely, the loss potential is unlimited in nature. Once the stock starts to move below the breakeven point in this trade, there is virtually no limit to the losses from this trade as the put buyer will "put" you into the stock if the price drops below the strike price at expiration.
Risk = Strike Price - Put Premium Received
Potential Profit = Net Credit Received from Put Premium
Breakeven Point = Strike Price - Option Premium Received
Naked Put Trading Example
So, its October 1st, 2008 and MSFT is trading at $26. An options trader believes that MSFT has bottomed at $23.50. So, the trader wants to capitalize on the potential market rally and wans to sell the October $32 MSFT puts for $5.80. If MSFT closes at $34 on options expiration, the puts will expire worthless. Thus the options trader would make 100% on their money. However, if MSFT is at $20 dollars, the put option will be worth $12 dollars and the trader would be down 228%. So, as you can see the risk to the downside is unlimited. The worst case scenario would be if the stock goes to zero.
Requirements to Trade Naked Puts
Due to the increase risks associated with trading naked puts, their are strict margin requirements set by brokers.Trading naked puts should only be used if the trader has siginificant experience trading options and substantial investment capital. Additionally, most brokerage houses require that you have the funds available in cash to purchase the stock at the option strike price if the option is exercised.