What Is A Naked Put and How Does It Work

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.

• Receive cash flow: You receive the premium right away and can use the funds as you wish. 
• You can lower your cost basis: If your option contract gets exercised, the premium acts as a cushion. If your option gets exercised with a $70 strike price, your cost basis is not $70 per share. It’s the difference between the strike price and the premium. If you earned a $3 premium for opening the naked put, your cost basis is only $67 per share if the put gets exercised.
• Free up your money for other investments: A cash-secured put ties up your capital until the contract expires or gets assigned. Naked puts free up more of your cash, which gives you more capital to diversify into other investments. However, if assigned, you may face financial strain due to insufficient funds to meet your obligation.
• Declining implied volatility can be beneficial to the options seller: Implied volatility is a key metric that impacts an option’s value. A higher implied volatility will result in higher premiums, and some investors may initiate a naked put when the implied volatility is high. Implied volatility tends to drop as an option gets closer to expiration and puts downward pressure on the option’s value. However, rising implied volatility will increase the naked put’s value, and other factors also contribute to option price fluctuations. Companies with earnings reports coming up tend to have higher implied volatility.

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.

• Your options can get assigned: Some traders enter too many naked put positions hoping these contracts will never get exercised. Using too much margin can become troublesome if the underlying stocks do not move in your favor. 
• Your additional investments can decrease: Naked puts give you more money to invest, but not all capital generates positive returns. Putting too much capital into additional investments can make an investor more vulnerable to a margin call. Investors should carefully monitor their margin and assess their risk tolerances before getting started with naked puts.

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