Selling Naked Puts
October 18, 2002
The selling of naked options is a risky proposition. However, there is one situation in which selling an uncovered option is a play with reasonable risk.
Let's begin with the concept of a naked option. When you write (sell) a call option, you may be obligated to sell 100 shares of the underlying stock at the strike price. If you own the stock and have it in your account, then you are "covered." When covered, you have the ability to use stock already in your possession to fulfill the obligations of the option contract. If you do not own the stock, then you are "uncovered" or naked.
If you sell a naked call option and the stock trades above the strike price when expiration arrives, you are assigned on the option and are forced to deliver stock to the option owner. You may not be forced to buy the stock immediately, and may be allowed to carry the stock "short" in your account. However, you will have to buy that stock at some time in the future. Since there is no limit to how much the price of the stock can increase, your potential loss is unlimited. For that reason, selling uncovered call options is a very risky policy. I recommend you do not consider selling naked call options.
The situation is similar with naked puts, but there is a difference. If you sell a put option and have a short position in the stock, then you are covered. If you are assigned on the put option, you are obligated to buy the stock in order to fulfill the obligations of the option contract. Because you can use that stock purchase to offset your current short position, you are covered. If you do not have a short position in the stock, then you are uncovered.
When assigned, if you have sufficient cash in your account to buy the stock, there is no problem. You simply pay for the stock. The risk is much greater if you do not have sufficient cash. In that event, you have two choices: You can borrow cash from your broker and trade on margin. Alternatively, you can close some of your positions to raise the required cash. Being forced to close positions at a time NOT of your own choosing is not a pleasant event. Thus, the selling of an uncovered put option can be a risky proposition if you do not have enough cash in your account to cover the purchase.
Thus, our recommendation is to sell naked options under only one condition:
- It is a put option
- You have the cash in your account to purchase the stock, if assigned on the put.
When would you consider selling a naked put?
If you are considering buying stock, the usual procedure is to pay cash and buy the stock. An alternative is to sell the put and keep the cash available to buy the stock if assigned on the option. Let's compare the alternatives:
Buy the stockSell the put instead of buying stock
- Buy 100 shares of XYZ stock. Price 40. Investment is $4000.
- Maximum loss $4000 (stock goes to zero)
- Maximum gain is unlimited
If you sell the put instead of buying stock, your maximum loss is reduced by the amount you collect from selling the put. That is good, for it reduces your loss if the stock declines in price. The bad news is that your maximum gain is limited to the amount you collected from the option sale. Although you maximum gain is limited when selling the put, selling the put reduces the risk of stock ownership and is therefore a reasonable alternative to buying stock.
- Sell 1 XYZ Apr 40 put for 4. You collect $400
- Cash position $4400. (Your reserve of $4000 plus the proceeds from the put sale)
- Maximum gain is $400. (If the option expires worthless)
- Maximum loss $3600. (If you are forced to buy the stock for 40 and it becomes worthless)
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