What are Naked Puts?
A naked put, also called an uncovered put, is an extremely risky form of options trading where the options trader does not own a position on the underlying asset being traded. If the option is not exercised before expiration, the entire premium on the option goes to the seller of the option.
This is a highly speculative form of options trading as the trader stands to win big if he is able to correctly predict the direction that the price of the underlying asset will go to, but will lose everything if he gets the call wrong and the price moves in the opposite direction. The strategy for a naked put option is to go bullish so as to profit from the collection of trade premiums.
Let us take an example using our stock XY, which is presently trading at $43 in April 2012. The trader places a naked put option contract at $2 per share as follows:
– Sell 1 XY 45 Put @ $2 per share ($200)
The trader will collect a premium of $200, pending the expiration of the trade.
The breakeven point from a naked put occurs when the price of the asset on expiration is equal to the strike price. In our trade example, this is at $45.
Profit for a naked put option is limited to the premium on the trade. Since the trader does not have a short position on the underlying asset, he will not incur any loss if the option expires worthless at a price above strike price. From our example above, the premium is $200.
A loss on a naked put occurs when the price of the underlying asset on expiration is less than the strike price. The loss on a naked put is unlimited since it is not covered and no one can predict how far a stock will fall, especially in a period of economic crisis (such as occurred immediately after 9/11 and after the collapse of Lehman Brothers in 2008). The premium previously collected can help to cushion the effect of this loss, but that is as far as it can go.
From our example, if the stock XY closes at below the $45 strike price (e.g. at $40), the trader will have to sell back the option to the seller, with a $5 reduction in the price factored in as follows:
Loss = (Strike Price of Short Put (45) – Price of Underlying asset (40) – (Premium Received (2) + Commissions Paid).
Loss = 5 – 2 = $3 per share.
So the trader will incur a loss of $3 per share or $300 for the contract, less commissions paid.
Naked puts are a risky way to trade options. The trader has to get his analysis spot-on for the underlying asset otherwise he will not only lose, but lose to the extent to which the price of the asset will fall. Any bad news regarding the underlying asset in which he has the naked put option trade could jeopardise the trade. The trader must be sure that there is a bullish factor affecting the asset before taking this trade.