The ideal scenario when selling OTM uncovered puts is when the underlying does not breach or approach the short put's strike price over the life of the trade due to the stock price remaining constant or rising so that it can expire worthless at expiration to yield a maximum profit. However, when selling ITM naked puts, investors require a much larger upward price move so the option goes OTM and, ideally, expires worthless to yield a maximum profit.
OTM puts are usually valued less than ITM puts, and that's because they only have extrinsic value and no intrinsic value. ITM options have intrinsic and can have extrinsic value. Intrinsic value describes an option's immediate value for being ITM, while an option's extrinsic value depends on several factors, such as time or volatility.
Time decay can help erode an OTM put option's value when the underlying price remains stable and doesn't approach the short put option's strike price. Moreover, time decay can also benefit investors holding a naked ITM options position if it has any extrinsic value. However, potential profits on a short ITM put are generally more pronounced when the price of the underlying rises, ideally above the short put strike, so it does not have any intrinsic value.
Aside from holding the naked put to expiration to yield a max profit, investors can also profit by buying (covering) the short put back before it expires at a price lower than the initial sale price. On the contrary, investors can incur a loss when covering a short put at a price above the initial sale price.
It's also worth noting that ITM options generally have higher options (early) assignment risk than OTM options. When investors are short a put, it can convert to 100 long shares per contract before expiration, and investors will assume the risk of long shares after assignment.
Short puts are allowed in all account types. However, puts sold in a cash account must be completely cash-secured, which means the account must have the notional value of the put contract as available options buying power to establish the position. Puts sold in a cash account are called cash-secured puts instead of naked or uncovered puts. For example, selling a 50-strike put will require at least $5,000 of options buying power ($50 strike price x 100 options multiplier) in cash accounts. On the other hand, Margin accounts generally require a lower buying power requirement, Reg-T requirement, when selling naked puts or short option positions.
Expiration Risk for Naked Puts
Options that expire in the money by $0.01 or more are auto-exercised, resulting in an assignment of 100 long shares of stock for each ITM short put.
Moreover, any options strategy involving short options, including a naked short put, may face after-hours risk on the day of expiration. In summary, although the short put may have expired OTM based on the stock's closing print, an OTM short put option can become ITM based on any extreme downward price movement after the market close, resulting in an unexpected assignment of long shares. As a result, the investor would assume the risk of 100 long shares per contract assigned. The only way to eliminate after-hours risk is by closing any short options positions before expiration.
