Naked Put Basics

Selling naked puts is one of my favorite strategies. The implications are profound - you get paid to make an offer to buy shares of a stock for less than what they're currently trading at.

Naked Put Overview

It's not really even a metaphor. Writing naked puts is literally a method of acquiring stock for a substantial discount.

Quick Link - Basic Stock Option Definitions and Terminology

Here's how it works: You would sell 1 out of the money put at a strike price at which you are able and willing to purchase 100 shares of the underlying stock.

In exchange, you receive a cash premium. As long as the closing price remains higher than the strike price, the premium you receive is complete profit, and you are free to write or sell another naked or cash-secured put following expriration.

If the closing price ends below the strike price, you will be obligated to purchase the stock at the strike price. You can also buy back the put option prior to expiration, presumably (but not necessarily) for a loss.

Writing Puts - Becoming an Insurance Company for Stocks?

For a long time, I viewed writing puts as a version of being an insurance company. It is, after all the other side of the protective long put trade. When you write a put, you collect a premium in exchange for essentially insuring a stock at a certain price (i.e. the strike price).

You can approach the put writing this way, but there are some fundamental drawbacks to doing so:

• First, real insurance companies do not insure personal property without purchasing some form of reinsurance themselves in case of true, widespread catastrophe. That makes the bull put spread, bear call spread, and iron condor option trading strategies much closer to actual insurance operations.
• A second, and more subtle, drawback is that writing naked puts as an insurance underwriting strategy leads to ambivalent trading. If you only write naked puts on stocks you really want to own, how do you define success? When the stock goes up and you keep the premium but miss out on ownership? Or when the stock takes a dive and you're there to catch it?

Most likely, you'll end up selecting stocks not because you want to own them (or wouldn't mind owning them) but because you don't think their share price will drop below the strike price between now and expiration.

That's a great way to assemble a pretty lousy portfolio of formerly hot stocks you may or may not believe in or even like.

If, however, you view writing naked or cash-secured puts primarily as a mechanism to acquire shares in companies you really want to own at subtantial discounts, not only will your selection improve, but arguably so will your returns.

Really consider the profound implications of this trade. For each contract you write, you're getting paid to make an offer to buy 100 shares at a price lower than what the stock is currently selling for.

In fact, I would argue that you're almost always better off selling puts rather than buying stocks.

Naked Puts - Example

The entire stock market seems to be in a funk. The economy's in the doldrums and pessimism is currently reigning on Wall Street. Even The XYZ Zipper Company is feeling the pinch as consumers tighten their belts, so to speak, and seem to be wearing their pants longer (as in duration). As a result, the stock is trading all the way down at $21.50/share.

Sure, the short-term outlook isn't exactly rosy, but you're a believer in The XYZ Zipper Company's long-term prospects. You like the stock at the current price, but, savvy investor that you are, you decide to sell naked puts on the stock and see if you can't get the shares even cheaper.

And if you can't? No big deal - you'll be content with a generous return in the form of collected premium for your time and trouble.

Because overall stock market volatility has increased, you're pleased to discover that two months out, XYZ put options at the $20 strike price are trading for $1 even. You quickly write the option and immediately add $100 to your brokerage account cash balance.

Selling Puts - Scenarios

If the stock stays above $20 for the next two months, you're under no obligation to do anything other than enjoy your $100 as the put option expires worthless. In this example, that equates to a 5% return in two months ($100 divided by the $2000 you would be obligated to fork over should the put option be exercised), or a 30% annualized rate.

That's a reasonable consolation to keep in mind if the stock rebounds strongly and you miss out on a big move upward. Like covered calls, frequently the greatest risk with naked puts is that of missed opportunity.

If the stock continues lower and closes at expiration below $20/share, you will be obligated to purchase it for $20/share.

But the $100 premium you receive effectively lowers your cost basis to $19/share. Yes, the stock could always tank in a big way, but purchasing a stock for $19/share that you were originally prepared to buy for $21.50 gives your portfolio an extra advantage that regular stock owners never get.

Naked Put Variations

As with covered calls, you can monkey around with the strike prices. If you're feeling particularly bullish, or if you believe the stock will probably rebound, you can always write naked puts in the money.

For example, say the stock is trading @ $25/share and you decide to sell the $30 put options six months out for $7.50/contract.

$5 of the $7.50 is intrinsic value, the fact that you're basically offering to buy something for $5/share more than it's currently selling for.

Granted, you could probably earn more than $2.50/contract in time value premium by writing the naked puts closer to or at the money, but if the stock does move up during those six months, you enable yourself to participate in up to $5/share capital appreciation along in addition to the time value.

NOTE: Writing in the money puts is definitely more aggressive (i.e. higher risk) than writing them out of the money, or at strike prices below the current share price.

What's the Difference Between a Naked Put and a Cash Secured Put?

The short answer: not much.

A cash secured put is fairly self-evident. If you write put options against a stock and you hold enough cash in your account to purchase the stock outright should the option be assigned, you have written a cash secured put.

But you have also written a naked put. So what makes it naked?

Basically, any short put position is considered to be "naked" if it isn't "covered" by a corresponding short stock position (forming a covered put), or along with some other offsetting option position such as a long put at a lower strike price to form a bull put spread).

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