What is a Naked Put?
What is the financial definition of uncovered puts?
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Table of Contents
What Is A Naked Put
A “naked put”, also referred to as uncovered put or short put, refers to an investment strategy adopted by an investor selling “put options” without holding a short position on the put option’s underlying stock.
Said differently, an uncovered put writing is when a trader or investor sells put options without having an offsetting position in the underlying stock or having enough funds to fulfill the purchase of the stock.
An investor can make a profit by selling put options when the underlying security price goes up.
A put option is an option contract where the option holder (buyer) is entitled to force the option writer (seller) to buy the underlying asset at a specific strike price at any point in time until the expiration of the option contract.
By selling a naked put, you are committing yourself to purchasing the underlying stock with funds that you may not have at the time the option buyer exercises the put option.
Objective of Selling Naked Puts
The main objective in trading naked put options is to materialize the option’s premium on the underlying security when the investor expects for the underlying security price to go up.
The trader’s assumption in selling or buying naked puts is that the underlying stock or security price will fluctuate.
To earn a profit, the seller of a nake put must see that the price of the underlying stock goes up.
As the underlying stock price goes up, the value of the put option goes down, and the option holder will have no incentive to acquire the securities under the options contract from the seller of the put option.
For this reason, the seller of the put options will get to keep the premium paid on the options.
The option seller can earn a profit up to the value of the premium received for selling the put option contract.
The option buyer can earn a profit representing the difference between the strike price and the market value of the stock (if the stock price is below the strike price).
Profits And Losses on Naked Puts
From an investor’s point of view, the most money it can lose when selling a naket put is the option contract’s strike price.
For example, if the underlying equity price drops down to zero, the option buyer can force the seller to buy the stock at the strike price although it’s worth zero.
From an investor’s point of view, the maximum profit on naket puts is the premium it receives when selling the option contract.
The seller of the put option hopes that the underlying stock price goes up thereby rendering the put option contract worthless.
From an option buyer’s point of view, the maximum profit is the value of the put option strike price and the maximum loss is the premium paid for the put option contract.
How Does It Work
To get a better sense of how the strategy of buying naket puts or selling them, let’s look at how this investment strategy works.
First, a “put option” is a type of option contract where the option holder has the right to sell a specific number of shares of an underlying stock at a specific price during the term of the contract.
For example, if a person buys a put option for 100 shares of Company ABC at a strike price of $50, the option holder, until the option contract expires, can sell the stock of Company ABC to the seller of the option contract at $50.
In this scenario, the option buyer can earn a profit if the stock price goes down.
For example, if the stock price goes down to $20, the put option buyer can buy 100 shares in the stock market at $20 per share and force the seller of the option to buy the shares at $50 (providing the option holder a profit of $30 per share).
Conversely, the seller of a put option can stand to earn a profit if the value of the underlying stock goes up.
In that case, the option holder has no incentive to buy the stock on the open market and sell it to the put option seller at a lower price.
Now, the reason why we call this investment strategy a “naket put”, or “uncovered put” is due to the fact that the seller of the put option does not have an offsetting short position on the stock.
Since the seller of the option does not have a trading position to fulfill its obligations under the put option contract should the option holder decide to sell to it the underlying stocks, the trader’s investment position is said to be uncovered.
Naked Put vs Covered Put
What is the difference between a naked put and covered put?
A naked put is when an option trader sells a put option obligating itself to buy (or get “put” to it) a certain number of shares in an underlying security for a certain strike price during a specific period of time.
The position is “naked” as the option seller does not have a corresponding position in the underlying stock to offset the possibility of the option holder exercising its options.
For a nake put option, the trader can offset the put option contract by short selling the underlying stock.
A covered put is when the trader or investor has a corresponding and offsetting position in the underlying stock when selling a put option.
In this case, the investor will short sell the underlying stock and sell a put option.
If the put option holder exercises the options forcing the investor to acquire the underlying stock, the investor can then offset this forced acquisition by closing out the short position on the same security.
The investor or a covered put strategy expects to earn a profit when it forecasts a slight decline in the underlying stock price.
Naked Puts Takeaways
So, what are naket puts?
Let’s look at a summary of our findings.
Naked Put Options
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