Shorting Naked Puts
Strategy Overview – Uncovered “Naked” Puts
Shorting an uncovered or “naked” put is a speculative strategy. You receive a premium for selling the put, and you are obligated to potentially buy the underlying security at the option's strike price. You need an account with margin to sell a naked put.
Why would you sell a naked put?
You could sell a naked put to produce income (through the premium received) or to possibly purchase the underlying security at less than the current market price. Selling a naked put allows you to leverage the existing funds in your account.
Selling a naked put is considered a bullish strategy. If your objective is to profit solely from the premium received, you would likely have a bullish outlook for the length of the option's life. If your objective is to acquire the underlying security, you would likely have a longer-term bullish view.
What happens if the option is in the money at expiration?
If the put option is 1 penny ($0.01) or more in the money (meaning the market price is lower than the strike price) at expiration, the option will likely be assigned and you will be obligated to buy the underlying security at the put option's strike price. Since this strategy is naked, you may not have all the cash needed to purchase the security in reserve. You would be required to use your margin buying power or deliver the necessary funds to purchase the underlying equity.
What happens if the option is out of the money at expiration?
If the put option expires out of the money (meaning the market price is higher than the put strike price), the option expires worthless and your obligation to buy the underlying security expires as well. You will retain the premium.
How to Calculate Max Profit, Break-Even and Max Loss
The maximum profit from a naked put is the premium received, minus commissions and fees. The break-even point is the strike price minus the option premium or the price at which you would start to incur a loss. The maximum loss assumes you would purchase the underlying security and its price falls to zero. The loss would be partially offset by the premium.
Profit and Loss Graph
On the profit and loss graph the vertical axis represents the profit or loss potential. The horizontal axis represents the security's price from low to high (left to right). The point where the profit and loss line crosses the horizontal axis represents the break-even point.
This illustration is hypothetical and does not reflect actual investment results or guarantee future results.
The following factors will influence an option's premium and should be considered when implementing an option strategy.
Volatility: Periods of higher-than-normal volatility tend to cause option premiums to rise. Periods of lower-than-normal volatility tend to cause option premiums to decline.
Time Decay: The value of an option declines to its intrinsic value as it approaches expiration. The rate of decline increases as the option gets closer to expiration. Time decay can benefit the seller of an option and be a detriment to the buyer.
Delta: Delta helps measure the amount that an option's price could change relative to a one-point move in the underlying security's price. Out-of-the-money options tend to capture less of a price move than in-the-money options.
Assignment: Assignment happens when the owner of the put option exercises his right to sell the underlying security at the option's strike price. Assignment can happen at any time with an American style option, but is unlikely if the option is out-of-the-money or still has time value built into the option's premium. A European-style option can only be exercised/assigned at expiration.
Read Next: Strategies for selling puts
Options involve risk and are not suitable for all investors. Detailed information on our policies and the risks associated with options can be found in Scottrade's Options Application and Agreement, Brokerage Account Agreement, and by downloading the Characteristics and Risks of Standardized Options booklet. You can also order a copy of the booklet by phone at 1-888-OPTIONS or obtain a copy at a Scottrade branch office. Market volatility, volume, and system availability may impact account access and trade execution. Consult with your tax advisor for information on how taxes may affect the outcome of these strategies. Keep in mind profit will be reduced or loss worsened, as applicable, by the deduction of commissions and fees.
There are special risks associated with uncovered option writing that may expose investors to significant losses. There¬fore, this type of strategy may not be suitable for all customers approved for options transactions. Clients approved for uncovered put writing must acknowledge having received and read the Special Statement for Uncovered Options Writers concerning the risks of this type of trading.
Margin trading involves interest charges and risks, including the potential to lose more than deposited or the need to deposit additional collateral in a falling market. Scottrade's margin agreement is available at scottrade.com, or through a Scottrade branch office, and contains the Margin Disclosure Statement and information on our lending policies, interest charges, and the risks associated with margin accounts.
The analytical tools and strategies described in this article are for information purposes only and their use does not guarantee a profit. None of the information provided should be considered a recommendation or endorsement of any specific investment, tool or strategy. The choice to engage in a specific investment, tool or strategy should be based solely on your research and evaluation of risks involved, your financial circumstances and investment objectives. Securities are subject to market fluctuation and may lose value. Market volatility, volume, and system availability may impact account access and trade execution.
Examples used will not show the deduction, or inclusion, of commissions and other costs that may significantly affect the performance of the given strategy. They do not take into consideration tax consequences or fees with minimal impact on a given strategy. An investor should understand the impact of transaction costs, margin fees and requirements, and tax considerations before entering into any options strategy. Consult your tax, or legal, advisor for questions concerning your personal tax or financial situation.