What it means
A put option gives the buyer the right to sell shares at a fixed strike price before a set date. The put writer takes the other side of that deal and must buy the shares at the strike price if the buyer exercises.
If the writer has set aside enough cash to do so, the put is cash-secured, and if not it is naked. The writer profits if the share stays above the strike price, because the option expires worthless and the premium is kept.
The maximum profit is this premium. If the share falls well below the strike, the writer has to buy shares at a price higher than the market value.
The potential loss is large but capped, because a share price cannot fall below zero. The worst case is the strike price less the premium, multiplied by the number of shares.
That can still be a very large sum relative to the account. A naked put also exposes the writer to a practical timing risk.
The buyer can in many cases exercise before the expiry date, so the writer may be handed shares well before they planned for it. Brokers require margin for naked puts, and the amount can climb quickly if the share price declines.
A trader who cannot meet a margin call may be forced to close the trade at a loss, even if the share later recovers. This is why position size matters as much as direction.
Some investors sell puts on companies they would be happy to own, treating the strike as a price at which they would gladly buy. This only works well when they have the cash ready and genuinely want the shares at that price.
In practice
Real-world examples.
Example
An investor sells a naked put on a software company at a $60 strike for $3 a share. The share sinks to $45 after poor results, and he faces a loss of $1,200 on the contract at expiry.
Example
A small fund sells puts on an exchange-traded fund every month to collect premiums. A sudden market sell-off triggers a margin call, forcing it to sell other holdings to raise cash. Selling those other holdings in a falling market locks in further losses.
Example
A retired engineer sells a put on a bank she admires at a strike of $30, keeping $5,000 in cash as security. This makes it cash-secured rather than naked, and if the shares are delivered she is happy to own them.
Formula
Calculation
Breakeven price = Strike price - Premium per share
Maximum profit = Premium per share x 100
Maximum loss = (Strike price - Premium per share) x 100
A trader sells one put with a $40 strike for a $2 premium, receiving $2 x 100 = $200. The breakeven price is $40 - $2 = $38.
If the share finishes at or above $40, the trader keeps the $200. If the share finishes at $30, the loss is ($38 - $30) x 100 = $800. If the share collapses to $0, the maximum loss is ($40 - $2) x 100 = $3,800.Case study
Seen in the real world.
Marlow Wealth is an illustrative, fictional advisory boutique. One of its partners began selling naked puts on well-known consumer brands, collecting about $12,000 a month in premium and describing it as a reliable income stream.
During a sharp market fall, several of the shares dropped by more than 25% in a week. The partner's margin requirement tripled, and the firm had to inject $400,000 of its own cash to keep the positions open.
In this illustrative story the managing partners capped the size of any single short option position at 5% of capital and required cash to be set aside. The episode showed that a strategy with frequent small gains can still hide rare, large losses. The partners also agreed to run a stress test every quarter that assumes a 30% market fall.
Watch out
Common mistakes.
- Thinking a naked put is safe because the share price cannot fall below zero, when the loss at zero is still very large.
- Selling puts on shares one would not want to own, so that being assigned becomes a problem rather than a plan.
- Underestimating margin, which can rise rapidly in a falling market.
Questions
People also ask.
What is the difference between a naked put and a cash-secured put?
A cash-secured put has enough cash set aside to buy the shares, while a naked put relies on margin.
What happens if the buyer exercises a naked put?
The writer must buy the shares at the strike price, whatever the market price is. If the writer lacks the cash, the broker may sell other assets or close the account.
Can you lose more than you invested?
On a naked put the loss is capped at the strike less the premium, but that can be many times the premium and may exceed the cash in the account.
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