The stock market gives investors different opportunities to possibly generate returns, but you don’t have to own stocks to potentially accumulate profits. A naked put is an options trading strategy that does not require you to hold onto any stocks. Some investors use naked puts to receive cash flow from the option’s premium. Understanding how naked puts work may increase your portfolio returns and cash flow though it comes with substantial risks as well.
What Is a Naked Put?
A naked put is a put that does not have any cash secured to the position. You can sell a naked put and use the remaining cash in your portfolio as you wish instead of tying it up to the option contract.
Keep in mind that naked put options trading is a highly risky strategy that involves significant exposure to potential losses, especially when considering the limited gain exposure and large downside risk. If the stock goes to zero, an investor could lose the most--a high risk when compared to the maximum possible gain of just earning the premium. Before engaging in this trading strategy, it is essential for investors to fully comprehend the associated risks and carefully consider whether it aligns with their financial goals and risk tolerance.
Naked Put vs. Cash-Secured Put
Both puts tend to do well when the underlying stock’s price increases, and some investors use these options to lower their cost basis. The difference between these options contracts lies in the collateral. A naked put does not have any collateral tied to it, while a cash-secured put requires a secured cash deposit to buy the stock if assigned.
If you sell a put with a strike price of $50, you have to put down $5,000 for a secured put. The $5,000 is enough capital to buy 100 shares if the stock’s price falls below $50 per share. You cannot access the cash from a secured put until the contract either expires worthless, or you buy the put to close the position.
Furthermore, you have the same position with a naked put, but you do not have to put down $5,000. You can invest the $5,000 in any way you wish while waiting for the naked put to expire or get exercised.
Remember, naked put options trading involves significant risks, including a substantial loss potential, an obligation to purchase the stock at the strike price if assigned, and exposure to market volatility. Going back to the previous paragraph, if you get assigned while holding a losing stock position with the $5000 you invested, you may face financial strain due to insufficient funds to meet your obligation.
This speculative strategy is usually more appropriate for experienced investors with high-risk tolerance. Diversification and regular monitoring of positions are essential. Consider seeking advice from a qualified financial advisor before engaging in naked put options trading to fully understand the risks and make informed decisions.
How Does a Naked Put Work?
A naked put is a bit more complicated than buying and selling stocks, but they get more straightforward once you understand the basics. These key details can help you feel more confident with trading naked puts.
Maximum Profit
The maximum profit is the premium you make from selling the put. If you receive a $2 premium, you cannot make more than $200 from the naked put. You can generally increase the premium received by selling a naked put with a strike price closer to the underlying price, but that also increases the risk of getting assigned.
Maximum Loss
The maximum loss for any put contract is the difference between the strike price and the premium. If you make a $1 premium on a contract with a $25 strike price, your maximum loss is $24 per share, or $2,400 (most option contracts represent 100 shares).
Breakeven
The breakeven for a naked put is the strike price minus the premium. If you sell a naked put with a $100 strike price and receive a $5 premium, your breakeven price is $95 per share. Any cent above $95 is a gain, while any cent below $95 represents a loss.
Volatility
Naked puts, like any option contract, are more volatile than the underlying asset. Options can experience dramatic price swings, especially if you trade options before earnings or the release of new economic data. A company with higher volatility will typically command higher premiums than a company with lower implied volatility, all other factors being equal. However, implied volatility gradually decreases over time and can reduce the value of an options contract. Implied volatility can decrease sharply after an earnings report.
The quick implied volatility drop may not give options traders much time to make up losses if the earnings report is unfavorable for them. Higher volatility doesn’t necessarily make one choice better than the other but is good to consider for risk management.
Time Decay
Time decay represents how the distance from today to the option’s expiration date impacts the naked put’s value. An option with one year left before expiration has more time value than the same option but with only one week left before expiration. Options become less valuable as time passes.
Possible Advantages of Naked Puts
Opening naked puts has some advantages that can strengthen your trading strategy.
Income Generation
Selling naked puts can offer the benefit of income generation. Sellers receive a premium from buyers upfront, which results in a cash flow. This can serve as a reliable income source, particularly if the seller often engages with options trading.
Potential for Acquiring Stocks at a Discount
If the stock price drops below the strike price, the seller might have to buy the stock at that strike price. This allows for the chance to obtain shares at a price lower than the current market value, which may benefit long-term investors who are optimistic about the stock.
Flexibility
Selling naked puts gives sellers flexibility in their investment approach. They can select which stocks to sell puts on, helping them align their options trades with their market perspective and investment objectives.
Limited Risk
Selling naked puts does carry some risks, but the most you can lose is the difference between the strike price and the premium you received. If the stock price goes up or stays above the strike price, the seller can retain the premium without the need to buy the stock.
Market Neutral Strategy
Selling naked puts can be done in a market-neutral setting, allowing investors to support a stock while taking advantage of option time decay. This strategy is effective in a sideways market, where the seller can make a profit as long as the stock price remains above the strike price.
Things to Consider with Naked Puts
Naked puts can provide a different cash flow and give you more capital for other assets, but you should keep these details in mind before starting with naked puts.
Market Conditions
Before trading naked puts, it's important to evaluate the current market conditions. Consider market volatility, trends, and sentiment. High volatility can lead to higher premiums but comes with increased risk, whereas a stable market may provide lower premiums and potentially safer results.
Underlying Asset Selection
Choose the underlying assets for selling naked puts with caution. Focus on stocks that have solid fundamentals, consistent earnings, and a track record of low volatility. It's important to assess the company's performance and growth potential to reduce the risk of substantial price declines.
Strike Price and Expiry Date
Select suitable strike prices and expiration dates. A higher strike price can provide a larger premium but also comes with an increased risk of assignment. It is important to strike a balance between obtaining favorable premiums and minimizing the risk of being obligated to buy the underlying stock at a loss.
Risk Management
It's important to have a solid risk management plan in place. Figure out how much risk you're comfortable with and set stop-loss orders or exit strategies ahead of time. Be aware of what could happen if the asset declines significantly, and get ready for potential losses or the responsibility of buying the stock.
Margin Requirements
It's important to know the margin requirements for selling naked puts. Brokers need enough margin in your account to cover possible obligations if the puts get exercised. Make sure you understand the margin rules and have enough funds available to meet these requirements without putting your financial situation at risk.
Example of Using a Naked Put
Naked puts can provide steady cash flow and not require you to buy shares to hedge your position. If a stock trades for $100/share, a trader can sell a naked put with a $95 strike price for a $3 premium. The trader hopes that shares will not fall below $95/share. It is optimal for shares to rise after a trader opens a naked put.
If shares rise to $105 at expiration, the naked put will expire worthless and leave the trader off the hook. However, if the stock falls to $90/share at expiration, the trader will have to buy 100 shares of the company at $95/share. The investor will have to pay $9,500 to obtain 100 shares even though 100 shares are only worth $9,000. Traders can set strike prices further away from the market price to decrease the likelihood of getting assigned. It is also possible to close a naked put for more likely a loss before getting assigned if it becomes in-the-money.
Incorporating Naked Puts into An Investing Strategy
Naked puts can be a useful options trading strategy for some experienced investors with the potential to help increase returns and cash flow. You can collect premiums without owning stocks and aspire to keep it that way.
Remember that naked puts have limited income potential and very large downside risk. This strategy is highly risky and inappropriate for most investors, but those who can balance the risks and manage them well may see potential payoffs.
Frequently Asked Questions
How do you enter a stop order on a naked put write?
When placing a stop order on a naked put write, you usually set a stop limit price at which you are ready to buy back the put option if its value falls. This helps safeguard against potential losses by automatically executing a buy order when the option hits the designated stop price.
How much margin does a broker account give naked puts?
The margin needed for a broker account to sell naked puts differs by broker and is typically based on either a percentage of the underlying stock’s value or a set dollar amount for each contract sold. Generally, brokers may ask for a margin of 20-40% of the stock’s price, in addition to the premium earned from selling the put option.
Can naked puts be used as a standalone strategy?
Yes, naked puts can be used as a single strategy, enabling investors to earn income from premium collection while accepting the risk of needing to purchase the underlying asset at a lower price. It’s important to have adequate capital and risk management strategies in place since losses can be considerable if the market shifts negatively.
About Marc Guberti
Marc Guberti is an investing writer passionate about helping people learn more about money management, investing and finance. He has more than 10 years of writing experience focused on finance and digital marketing. His work has been published in U.S. News & World Report, USA Today, InvestorPlace and other publications.