Hedging Naked Puts

Question - How To Hedge A Short Put

I'm interested in hedging naked puts. Is there a good way to hedge naked puts? How would I best hedge a short put?

Answer

Terrific questions.

When it comes to hedging naked puts, the most effective technique is to initially set the trade up as a bull put spread.

Here's a quick summary of the differences between a naked put and a bull put spread:

When you write a naked put, you're simply offering to purchase 100 shares of a certain stock (the underlying) at a certain price (the strike price) on or before a certain date (the expiration date). In exchange, you receive a certain amount of premium in the form of cash added to your brokerage account.

As long as the stock closes at expiration at or above the strike price, everything works out fine for you - the naked put expires worthless, you're under no obligation to purchase the shares in question, and the premium you originally received is yours to keep with no further obligation on your part.

Of course, if the stock really takes a dive, the story is much different. You will be obligated to purchase the shares at the strike price, and the premium you receive may be little consolation if the stock falls significantly below the strike price.

A naked put (a short put) becomes a bull put spread when you add a second long put at a lower strike price.

For example, if the XYZ Zipper Company is trading at $26/share and you write one put at the $25 strike for a $1/contract premium and then purchase another put at the $22.50 strike for a $0.50/contract, you would have yourself a bull put spread.

You would also have less net premium but added protection - your maximum loss is the difference between the strike prices less the total amount of net premium received. In this example, that equates to $200, excluding commissions (the $25/strike minus the $22.50/strike = $2.50/contract less the net $0.50/contract premium . . . grand total = $2.00/contract or $200).

So the price for hedging naked puts by forming a bull put spread is that you relinquish your ability to achieve the maximum premium gains offered by the unhedged naked put.