Understanding Naked Put in Detail

Understanding how the trading sector works can get extremely overwhelming, especially if you are new to this world and possess little to no knowledge at all. Sure, executing trading requires a lot of potential, proficiency, risk appetite and understanding of strategies.

One such strategy that turns out to be helpful is naked put. In this post, let’s find out what exactly is naked put and who should go with this option.

What is Naked Put?

A naked put is referred to such an options strategy wherein the investor sells or writes, the put options without possessing a short position in the Underlying security. Sometimes, this strategy is also known as short put or uncovered put.

The major use of the naked put is to acquire option premium on the Underlying Security prediction that supports an increment, but one which wouldn’t leave an investor or trader disappointed for a few months or longer.

Explaining Naked Put

A naked Put Option strategy simply presumes that the underlying security is going to vary in value, but basically increases over the upcoming month or so. On the Basis of this assumption, a trader executes this strategy by selling the put option with no consistent short position in the account.

This sold option is regarded as uncovered because the initiator remains in no position to fill up the option contract’s terms if a buyer wishes to exercise the right to option. Considering that a put option is created to design profit for the trader who correctly anticipates that the security’s price will decrease, the naked put strategy doesn’t have any consequence if the price increases.

Under this situation, the put option’s value goes down to zero, and the option seller gets to retain the money received while selling the option. However, the only objective that the put options seller has is to see an increment in the underlying security price so as to gain the profit.

However, in case the price decreases, they may have to purchase the stock at last as the option buyer might decide to exercise the right to sell the security to somebody else. Traders who are inclined toward this strategy choose to implement the rules of naked put only on such underlying securities that seem favourable.

Evidently, the naked put option strategy is in contrast to the covered put strategy. In the latter, the investor retains the short position in underlying security for a put option. The puts and underlying security are shorted and sold in similar quantities.

When a covered put is executed in this way, it works virtually similar to the covered Call strategy, with the only difference being that the person executing the covered put anticipates getting profit from a mild decline in the security’s price. In contrast, the covered call anticipates getting profit from a mild increase in the price.

The reason behind this is that the underlying position for covered puts is relatively short, and instead of the call, the option that is sold is a put. Inherently, a naked put strategy is risky, owing to its restricted upside profit possibility and a theoretical downside loss probability.

The risk is associated with the fact that the maximum profit can only be acquired in case the underlying price is closing above or at the strike price during the expiry. Moreover, an increase in the underlying security’s cost is not going to generate any extra profit.

Notionally, the maximum loss is substantial because the underlying security’s price can go down to zero. Therefore, the higher the strike price, the higher will be the possibility of loss. But practically, the options seller may repurchase them before the underlying security’s price falls too far down the strike price.

How to Use Naked Puts?

As a result of the involved risk, only experienced and proficient options, investors must go forward with naked puts. Often, the margin requirements are high for this strategy because of the propensity of significant losses.

Investors, who believe that the price of the security will stay the same or increase might write put options to earn a premium. If the stock is above the strike price, the option's writer gets to keep the premium minus commission.

When the stock’s price goes below the strike price by or before the expiry date, the buyer of the options can demand to take the delivery of the share of the underlying security from the seller. Then, the seller will have to go to the open Market and sell shares at the market price while bearing the loss.