Naked Put Explained (Simple Guide)
How would you like to earn a significant return off of a stock that increases in value or stays the same? If so, then consider the naked put strategy.
A naked put, or a short put, involves selling a put option when you don’t have a short position in the underlying stock. You also don’t own the put option.
The idea is to sell it first, then buy it back later at a lower price and pocket the profit.
Alternatively, you can just let the put option expire worthless and keep all the money you earned when you sold it.
In this guide, I’ll go over the concept of a naked put so that you can determine if it’s an options strategy that’s right for you.
What Is a Naked Put?
Typically, you’ll sell a put option when you hold a short position in the underlying stock.
For example, if you sold short 100 shares of Intel, you can sell somebody else an right to sell those shares on a specific date at a specific price.
In the case of a naked put, you’re selling the option without holding a short position in Intel. That’s a distinction with a huge difference.
Why? Because if the trade goes against you (in this case, if Intel moves lower), then your losses could be significant. You’ll either have to buy back the option at a higher price or sell shares of Intel for a loss.
Naked puts offer limited return but significant risk.
The return is limited because the most you’ll earn is the credit you received when you sold the put option.
The risk is significant because the underlying stock can theoretically fall all the way to $0 per share. You’ll take a huge loss if that happens.
When Would You Use a Naked Put?
Use a naked put when you think the underlying stock is going up or will stay the same over time.
A naked put is like owning a stock. You make money when the underlying price increases.
However, you can also make money if the price stays the same.
Why? Because options are subject to time decay. Since they have an expiration date, they normally drop in value over time, all other things being equal.
Let’s say you buy an option that’s worth $5.00 today and the expiration date is a month out. You’ll notice that the option decreases in value as it gets closer to expiration, even if the underlying stock price stays the same or ticks up slightly.
When you short a put option, you’re letting time work in your favor. The longer you hold the option without a significant downside swing in the underlying stock price, the more likely you’ll earn a positive return.
How Does a Naked Put Work?
Before you even think about opening a naked put position, make sure that you have a margin account with your online brokerage.
In fact, you’ll likely find that you need significant margin to short a put option. That’s because the risk is significant.
Once you have your margin requirement satisfied, look for a stock that you think will go up in value or stay flat over the next month or so. Find some put options for that time period.
Next, identify the right strike price. That’s the price that you think the stock will not go below prior to expiration.
Finally, sell the put option for that strike price at that expiration. You’ll see that you get some cash credit to your account.
If the underlying stock stays the same or increases in price prior to expiration, the option will expire worthless. That’s a good thing in this case because you keep the money you earned when you sold the put option.
On the other hand, if the stock drops in value below the strike price, you’ll either have to buy back the option for a loss or sell the underlying stock for a loss.
Real Life Example Using a Naked Put?
Let’s say Apple is trading at $170 per share. You think it’s going to stay flat or increase over the next month, so you decide to short a put option.
You look at the options that expire about a month from now. The $170 put option is currently trading for $6.40.
You’re convinced that Apple won’t go lower than $170 over the next month, so you sell the option. That earns you $640 because options are traded in blocks of 100 shares ($6.40 x 100 = $640).
As time passes, Apple stays flat at about $170 per share prior to expiration. It doesn’t rise as you expected.
That’s not a problem, though, because time decay is eating into the value of the option. Since you’re short the option, you make money as its market price decreases.
The stock stays right around $170 per share at expiration. Your option expires worthless.
That’s good news because you get to keep the money you earned from selling the option. In this case, that’s $640.
So even though the stock stayed the same in value, it never crossed the strike price of $170. You made a good call and earned a positive return.
What Are Similar Strategies Related to Naked Put?
Here are a few strategies similar to a naked put:
- Long Call – Involves buying a call option instead of selling a put option. Although both strategies are profitable when the stock increases in value, there’s a key difference. Time is not on your side with a long call option. If the underlying stock price stays the same, time decay will eat into the value of the option and you’ll lose money.
- Covered Put – A covered put is like a naked put except that you own a short position in the underlying stock. You can buy that stock if the trade doesn’t go your way.
- Bull Put Spread – Similar to a naked put except that you hedge the position with a long put option at a lower strike price. That limits your loss.
Naked Put Compared to Other Options Strategies?
Many options strategies involve limited risk and limited return. A naked put involves significant risk.
Remember, the underlying stock can theoretically drop down to $0. If you’re short the put option for the stock when it tanks, your loss could be enormous. You might even wipe out your margin account.
That’s why a naked put is best left to very experienced options traders. If you haven’t yet traded naked puts, make sure you do some practice trading before putting your own money on the line.
Or, at the very least, hedge yourself with a bull put spread.
Advantages & Risks of Naked Put?
- Potential for significant returns – You can earn a much higher positive return by shorting put options than you can by shorting the underlying stocks. That’s because options use leverage.
- Time is on your side – Even if you were wrong about the underlying stock increasing in value, you can still win with a short put. If the stock price stays the same or just ticks down slightly, the option will drop in value thanks to time decay. Since you’re short the option, you make money when it drops in value.
- Potential for significant loss – Although you can earn high returns with naked puts, there’s also the potential for huge losses. It’s best to practice with short puts before you start trading with real money.
- Margin wipe-out – You might lose a significant amount of your margin when you place a bad trade.