What Is a Naked Put?

By Markets Fool.com

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There are plenty of ways to profit on a stock's movement beyond investing in the actual stock itself. Options provide a nearly endless array of strategies, due to the countless ways you can combine buying and selling call option(s) and put option(s) at different strike prices and expirations.

A call is an options contract that gives the owner the right to purchase the underlying security at the specified strike price at any point up until expiration. A put is an options contract that gives the owner the right to sell the underlying asset at the specified strike price at any point up until expiration.

While selling a naked call is a strategy where you're committing to sell stock you don't currently own, selling a naked put is committing to purchasing stock with funds that you may not have at the time.

Buying something with money you don't have

A naked put is when an investor sells a put option without having sufficient funds in the account to cover the purchase if the option is exercised. To set up a naked put, an investor simply sells a put option. The short side of the put option is required to purchase the underlying stock at the exercise price. Puts can either be naked or cash-secured. If the put is cash-secured, you have sufficient funds in the account to pay for the purchase.

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A cash-secured put would require $5,000 to be in the account, while a naked put would not. A naked put would require a margin account, and the broker/dealer would extend margin credit to cover any deficiency if the put is exercised. Even if the investor has sufficient funds in the account to cover the exercise, it can still be classified as naked if the account is approved for naked puts. In this case, the naked put has much lower capital requirements and the cash can be deployed toward other investments. In contrast, the funds allocated to a cash-secured put must always be set aside.

For example, if an investor sold a $50 put, it would require $5,000 to purchase 100 shares of the underlying stock. Let's say the premium received for the put is $4.

Maximum loss: strike price

The most that an investor can lose on a naked put is the strike price. This only occurs if the stock goes to $0, in which case the investor much purchase the stock at the strike price when it is worth nothing. The good news is that stocks don't often go to $0.

In this example, if the investor had to purchase shares at $50, but the company had gone bankrupt and the shares were worth $0, the loss would be $50 per share ($5,000 for 100 shares).

Maximum gain: net credit

For a naked put, the investor sells a put option and receives a premium in return upfront. The goal of the trade is for the option to expire worthless, in which case the investor keeps the entire premium as a gain.

In this example, if the stock stayed above the $50 strike price through expiration, it would expire worthless and the investor would keep the $4 premium.

Breakeven: strike price minus premium

The breakeven on a naked put is the strike price minus the premium received. If the stock closes upon expiration at that price, then the losses associated with the trade will exactly offset the upfront premium received.

In this example, if the stock closed at $46, then the $4 in premium received upfront would cover the $4 in losses related to buying the stock at $50 and selling it at $46.

Margin requirements

As mentioned above, the margin requirements for a naked put will be less than a cash-secured put. Broker/dealers are able to implement margin requirements that are stricter than regulations, which will vary between broker/dealers. Check with your broker/dealer for specific requirements.

From a regulatory standpoint, Regulation T requires:

  • Naked in-the-money put: 100% of the option market value plus 20% of the underlying equity price.
  • Naked out-of-the-money put: The greater of a) 100% of the option market value plus 10% of the underlying equity price, or b) 100% of the premium received plus 20% of the underlying equity price minus 100% of the out-of-the-money amount.

Naked puts carry substantially less risk than naked calls, but are still speculative in nature.

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