Editor's Note: Options are not suitable for all investors. Options involve risks, including substantial risk of loss and the possibility an investor may lose the entire amount invested in a short period of time. Please see the Characteristics and Risks of Standardized Options.
A naked put option, also known as an “uncovered put,” is a risky options strategy in which a trader writes (i.e. sells) a put option with no corresponding short position in the underlying asset. This strategy allows the trader to collect the option premium upfront, while anticipating that the underlying asset will rise in value. A naked put carries significant downside loss potential should the price of the underlying asset decline.
Key Points
• Naked put options involve selling a put without having a short position in the underlying asset.
• Naked put investors aim to profit from premium collection, while facing the potential for significant losses if the stock price drops.
• Approval for margin trading is necessary to engage in naked put options.
• Covered puts offer a hedge against losses by holding a short position in the underlying stock.
• Risk is limited to the difference between the option’s strike price and the market price, minus the premium received.
Understanding Naked Put Options
As a refresher, the buyer of a put option has the right, but not the obligation, to sell an underlying security at a specific price, called the strike price. On the flip side, the seller of a put option is obliged to purchase the underlying asset at the strike price if and when the option buyer chooses to exercise.
Writing a naked put means that the trader is betting that the underlying security will rise in value or hold steady. If, at the option’s expiration date, the price of the underlying security is above the strike price, the options contract will expire worthless, allowing the seller to keep the premium. The potential profit of the trade is capped at the initial premium collected.
The risk of a naked put option trade is that the potential losses can be much greater than the premium initially gained. If the price of the underlying security declines below the strike price, the option seller can be forced to take assignment of shares in the underlying security.
Taking assignment means that the seller must buy (typically) 100 shares of the underlying stock, per the options contract, at the strike price and regardless of the stock’s market value. The options seller would then have to either hold those shares, or sell them in the open market at a loss (since they were obligated to purchase them at the higher strike price).
Recommended: Buying Options vs. Stocks: Trading Differences to Know
Requirements for Trading Naked Put Options
Investors have to clear some hurdles before being able to engage in a naked put transaction.
Typically, that begins with getting cleared for margin trading by their broker or investment trading firm. A margin account allows an investor to be extended credit from their trading firm in order to actually sell a naked put.
There are two main requirements to be approved for a margin account in order to trade naked put options.
• The investor must demonstrate the financial assets to cover any portfolio trading losses.
• The investor must declare they understand the risks inherent when investing in derivative trading, including naked put options.
These requirements can vary depending on the broker and are also subject to regulatory oversight.
Selling Naked Puts
A trader initiates a naked put by selling (writing) a put option without an accompanying short position in the underlying asset.
From the start of the trade until the option expires, the investor keeps a close eye on the underlying security, hoping it rises in value, which would result in a profit for them. If that security loses value, the investor may have to buy the underlying security at the higher strike price to cover the position, in the event that the buyer of the put option chooses to exercise.
With a naked put option, the maximum profit is limited to the premium collected up front, and is obtained if the underlying security’s price closes either at or above the option contract’s strike price at the expiration date. If the underlying security loses value, or worse, the value of the underlying security plummets to $0, the financial loss can be substantial.
Naked Versus Covered Puts
As mentioned above, in a naked put, the trader has no corresponding short position in the underlying asset. This distinction is important due to the differences between naked and covered puts.
A covered put means the put option writer has a short position in the underlying stock. As a reminder, a short position means that the investor has borrowed shares of a security and sold them on the open market, with the plan of buying them back at a lower price.
This changes the dynamics of the trade, as a covered put involves holding a short position in the underlying asset. This offsets losses from the put option if the asset price falls. If the price of the underlying security declines, losses incurred on the put option will be offset by gains on the short position. However, the risk instead is that the price of the underlying security could move significantly upward, incurring losses on the underlying short position.
Recommended: The Risks and Rewards of Naked Options
Example of a Naked Put Option
Here’s an example of how trading a naked put can work:
A stock is trading at $50 per share. A trader opts to sell a put option expiring in 30 days with a strike price of $50 for a premium of $4. Typically, when trading equity options, a single contract controls 100 shares – so the total premium, their initial gain, is $400. If the price of the stock is above $50 after 30 days, the option would expire worthless, and the trader would keep the entire $400 premium.
To look at the downside scenario, suppose the stock’s price falls to $40. In this case, the trader would be required to buy shares in the stock at $50 (the strike price), but the market value of those shares is only $40. They can sell them on the open market, but will incur a loss of $10 per share. The trader’s loss on the sale is $1,000 (100 x $10), but is offset by the premium gained on the sale of the option, bringing her net loss to $600. Alternatively, the trader could choose not to sell the shares, but hold them instead, in the hope that they will appreciate in value.
There’s also a break-even point in this trade that investors should understand. Imagine that the stock slides from $50 to $46 per share over the next 30 days. In this case, the trader loses $400 ($4 per share) after buying the shares at $50 and selling them at $46, which is offset by the $400 gained on the premium.
The maximum potential loss in any naked put option sale occurs if the stock’s stock price goes to $0. In this instance, the loss would be $5,000 ($50 per share x 100 shares), offset by the $400 premium for a net loss of $4,600. Practically speaking, a trader would likely repurchase the option and close the trade before the stock falls too significantly. This can depend on a trader’s risk tolerance, and the stop-loss setting on the trade.
The Takeaway
The big risk of a naked put option trade is that the potential losses can be much greater than the premium initially gained, while the maximum profit is limited to the premium collected up front. The seller of an uncovered put thinks the underlying asset will rise in value or hold steady.
SoFi’s options trading platform offers qualified investors the flexibility to pursue income generation, manage risk, and use advanced trading strategies. Investors may buy put and call options or sell covered calls and cash-secured puts to speculate on the price movements of stocks, all through a simple, intuitive interface.
With SoFi Invest® online options trading, there are no contract fees and no commissions. Plus, SoFi offers educational support — including in-app coaching resources, real-time pricing, and other tools to help you make informed decisions, based on your tolerance for risk.
Photo credit: iStock/damircudic
INVESTMENTS ARE NOT FDIC INSURED • ARE NOT BANK GUARANTEED • MAY LOSE VALUE
For disclosures on SoFi Invest platforms visit SoFi.com/legal. For a full listing of the fees associated with Sofi Invest please view our fee schedule.
Options involve risks, including substantial risk of loss and the possibility an investor may lose the entire amount invested in a short period of time. Before an investor begins trading options they should familiarize themselves with the Characteristics and Risks of Standardized Options . Tax considerations with options transactions are unique, investors should consult with their tax advisor to understand the impact to their taxes.
Disclaimer: The projections or other information regarding the likelihood of various investment outcomes are hypothetical in nature, do not reflect actual investment results, and are not guarantees of future results.
Financial Tips & Strategies: The tips provided on this website are of a general nature and do not take into account your specific objectives, financial situation, and needs. You should always consider their appropriateness given your own circumstances.
SOIN-Q125-116