What is a naked put and how does it work?

What’s on this page?

1. What is a naked put?

2. What are the benefits and risks of selling naked puts?

3. How to trade naked puts with us

4. Naked put trading example

5. Naked puts vs covered puts

6. Managing risk when writing naked put options

What is a naked put?

A naked put is a type of options trading strategy where a market participant sells, or writes, a put option without holding a corresponding short position in the relevant underlying asset. When you sell a put option, you’re agreeing to buy the underlying at a specific price (the strike price) if the contract counterparty (the buyer) chooses to exercise the option.

This can be risky because the asset’s price can drop significantly, but you’d be obligated to make the purchase at the strike price – which, in such an instance, would be higher than the asset’s market price.

The main appeal of this strategy is the potential to profit from the options premium. It’s likely to be most useful when you’re neutral to bullish on an asset and wouldn’t mind buying it at a price lower than its current market value. However, if the asset’s price plummets, you could face substantial losses. That’s because there’d be no short position in place to offer you any protection – which is why the put in the strategy is said to be ‘naked’.

Naked puts are generally considered an advanced strategy and, as such, are often used by more experienced options traders who understand the risks involved.

What does selling a naked put mean?

When selling a naked put, you’re agreeing to purchase the underlying asset at the strike price if the put buyer chooses to exercise the option. You’re essentially providing the buyer with insurance against the asset’s price falling below a certain level. In return, you’ll collect a premium upfront.

This strategy typically requires a margin account to prove you can fulfil the potential obligation to buy. While selling naked puts can be profitable in stable or rising markets, it’s high risk and requires diligent risk management and consideration of factors such as the Greeks, implied volatility and – in the case of equity options – earnings releases and dividends.

What are the benefits and risks of selling naked puts?

Benefits:

• Potential profit through options premiums

• Potential to acquire assets at prices lower than their current market value

• Profit from time decay – options lose value as they approach expiration. You might try capitalising on this by buying your naked put back at a price lower than the premium you initially received

• Can be profitable in sideways or slightly bullish markets

Risks:

• Limit to the profit that can be made but no limit to the downside risk if the underlying’s price falls significantly below the strike price

• Potential for substantial losses that exceed the premium received

• Margin calls if the underlying asset’s price drops, requiring additional capital

• Increased risk during periods of high market volatility

• When trading equity options, there’s the risk of being assigned shares at an unfavourable price in a declining market

How to trade naked puts with us

1. Open an account with us

2. Choose your underlying asset

3. Take your position

4. Monitor and manage your position

Open an account with us

To trade naked puts with us, you’ll need a US options and futures account. This account enables you to sell options contracts (rather than just speculate on their prices), which is essential for the strategy. You can open a US options and futures account by filling in a short form, where we’ll ask you about your trading experience. Once we’ve verified your details, you’ll be able to fund your account and start trading online.

Choose your underlying asset

Use the search function on our US options and futures platform to find and select the asset you want to trade on. Make sure you do thorough research on the asset before taking your position.

Take your position

To execute the naked put strategy, sell a put options contract on your chosen underlying asset without having or taking any protective positions. You should select a strike price and expiration date that align with your market outlook and risk tolerance.

Monitor and manage your position

Monitor your trade carefully, particularly as the option approaches expiration. Stay on top of any market conditions, volatility or significant news events that may impact the underlying asset's price. If the asset’s price approaches or drops below the strike price, consider closing or adjusting your trade to manage your risk.

You should always assess potential losses and make informed decisions about letting the option expire, buying it back or rolling it to a later expiration date.

Naked put trading example

Let's say you write a put option for Meta with a strike price of $300 per share, expiring in one month. Based on current market conditions, options pricing models and demand for Meta shares, the option is priced at $10 per share or $1,000 ($10 x 100) for the contract, since each standard equity options contract represents 100 shares of the underlying stock. This is the premium you’ll receive for selling the put.

If Meta’s share price remains above $300, the option will expire worthless and you’ll keep the entire premium of $1,000.

Suppose Meta's share price falls to $280 at expiry. You’d be obligated to buy 100 shares at $300 each, even though the market price was lower. Your effective purchase price would be $290 per share (strike price of $300 minus the $10 premium received per share).

Here's a breakdown of the possible outcomes:

• Scenario A: share price above $300 at expiry. You keep the $1,000 premium

• Scenario B: share price at $280. You buy 100 shares at $300 each ($30,000) when they’re worth $280 each ($28,000), equating to a loss of $2,000. However, since you received a $1,000 premium for the put, your actual net loss would be $1,000

Naked puts vs covered puts

As we've explained, a naked put is an options strategy where you write a put option without holding a corresponding short position in the underlying asset. This exposes you to significant risk if the asset’s price falls because, if the contract counterparty chooses to exercise the option, you’ll need to buy the asset at the strike price. Naked puts can be employed using any of the listed options we offer.

In contrast, covered puts – which can only be executed using our listed equity options – involve selling a put option while shorting an equivalent amount of the underlying stock. This strategy helps limit potential losses, as the short position in the stock offsets some risks. Covered puts offer their writers immediate payment in the form of options premiums and can provide a hedge against market drops.

For naked puts, the maximum possible loss is theoretically infinite if the underlying asset’s price plummets to zero. As a result, many traders use this strategy only if they’re confident the asset’s market price will remain stable or increase slightly. With covered puts, the put option will – like with naked puts – result in a loss if the market price drops below the strike price and the contract counterparty exercises the option. That loss will, however, be partly offset by the short position in the underlying asset, which will benefit from the price decline.

Both strategies aim to capitalise on time decay of the option involved and stable or slightly changing market prices. However, naked puts require more margin and pose greater risks than covered puts. Covered puts are generally considered more conservative, blending the potential benefits of options writing with short-selling.

Deciding which of the strategies to use will depend on your risk tolerance, market outlook and available capital. It's crucial to understand the implications of both strategies and manage your positions carefully to mitigate risks.

Managing risk when writing naked put options

• Ensure you have enough cash or margin to cover any potential losses
• Diversify your options portfolio to spread out risk, eg writing puts with different strike prices and expiration dates
• Consider rolling the option out to a different expiry date
• Monitor market conditions and adjust your strategy accordingly
• Use position sizing appropriate to your available capital and risk tolerance
• Consider factors that could impact the price of the put (eg time decay and implied volatility) and the price of the underlying asset (eg earnings releases and dividends in the case of equity options)

Remember, while the above actions can help manage risk, writing naked puts remains a high-risk strategy that requires careful consideration and management.

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