Naked Put Assignment
Why Getting Assigned Early On Your Short Put Position Isn't That Big of a Deal
Naked put assignment is frequently one of those misplaced fears that keeps some individuals from writing puts in the first place.
Yes, selling naked puts can be risky, but the risk doesn't necessarily reside in the assignment - it comes from writing puts on either overpriced stocks or on businesses of questionable quality.
Quick review on naked puts and naked put assignment:
Selling or writing a put generates a cash payment (premium) in exchange for you agreeing to purchase 100 shares of the underlying stock on or before (if the holder of the put exercises it early) the expiration date should the stock trade below the strike price.
A naked put can be either cash-secured or margin-secured - it's considered "naked" because, technically, there's no additional downside protection in the event that the underlying shares trade all the way down to zero.
"Clothing" it, as it were, would consist of buying a separate long put at a lower strike price, thus forming a bull put spread. A bull put spread reduces your potential gains, but it also caps your risk.
If the stock is below the strike price at expiration, assignment is automatic, and you will find, come Monday morning, that you own 100 shares at the agreed upon strike price (plus commissions) for each short put contract assigned.
The person long the put that you wrote or sold, however, is under no obligation (in the U.S. markets) to wait until expiration to unload his or her shares, and, in fact, can exercise the put at any point (resulting in early assignment for you).
The Naked Put Conundrum
If you think about it, writing puts is a somewhat odd strategy. You're basically getting paid to offer to buy shares of a stock in the future for less than what they're currently trading at (that's true even for an at the money put since the net purchase amount would be the strike price less the premium received).
So what's the ideal outcome? You're offering to buy the shares, but do you really want them? Or do you just want the income from the trade?
If you're writing puts only for the income, then, yes, getting assigned early can put a crimp in your plans (although you can still "unassign" yourself as I explain elsewhere).
You vs. Mr. Market
If, however, you subscribe to the value investing with options methodology I advocate and practice myself, then early naked put assignment might very easily fit into your overall long term strategy of acquiring significantly discounted shares in high quality companies, and then continuously lowering your cost basis.
Still, as much as I want to acquire high quality companies at great prices, and as much as writing naked puts is one of my primary strategies to do so, I don't like it when Mr. Market tries to dictate the timing of my acquisitions.
On the contrary, I want to be the one who informs Mr. Market when the final deal actually gets done. And I'll roll, repair, adjust, and use every other trick in my bag, if necessary, to ensure that I'm the one in control of the situation, not Mr. Market.
Early Naked Put Assignment - Why it Happens
Just because a stock falls below your strike price so that the naked put in question, by definition, trades in the money, that doesn't mean that you're at great risk of early naked put assignment.
In fact, once you recognize the limited scenarios that do, in fact, increase the odds of early assignment, you can relax a little and just monitor your trade, taking action only when the situation warrants it.
The first thing that should reassure you is the fact that not every put option purchased is done so by a stock owner. Just because you sell a put, it doesn't mean that person on the other side of that transaction actually owns any shares.
I don't want to give the impression that assignment involves a 1:1 ratio between put seller and put buyer. Obviously, there are market makers who handle the bulk of the trades.
So, in effect, when a put gets exercised, the put writer who gets assigned is randomly chosen.
I don't have any stats to back me up, but my guess is that the majority of puts that are purchased are done so as a speculative bet on the direction or behavior or the stock, not as a protective hedge by actual shareholders.
As such, when someone long the put decides to close out the position early, that trader will therefore most likely just sell to close the put position rather than exercise the put (which wouldn't make sense if the trader didn't own the shares in the first place).
But under what conditions might the traditional hedger exercise the put early and force you to buy the shares?
You can check out Part 2 of this 3 part series by reading the article Avoiding Early Assignment on Naked Puts to see a couple of scenarios that increase the risk of early assignment.
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