Selling uncovered put options

The worst that can happen is for the stock price to fall to zero, in which case the investor would be obligated to buy a worthless stock at the strike price. The investor would have to scramble to deliver the cash by settlement day, and make urgent plans to resell the stock afterward. Both would increase the odds of assignment, which in this case is a very undesirable outcome. Second, the investor could select a strike price more cautiously; not on grounds of maximizing premium income. No matter how high the stock price rises, the most this investor can hope to earn is the initial premium. As a result, assignment would require urgent and possibly costly maneuvers to get hold of enough cash by settlement. If assigned, the goal would be to resell the stock as quickly as possible to minimize the duration and risk of stock ownership. Even if the investor felt that it had no correlation to a greater future risk of assignment, it would normally raise the cost of buying the put back to close out the position. As for that solution, it might be difficult and costly just when the investor would most want to exit: when the stock moves sharply downward. Second, the naked put writer has no interest in acquiring the underlying stock.

The option writer cannot know until the Monday following expiration whether assignment occurred or not. This method is second only to naked calls in its level of risk, and not suitable for most investors. The investor is expecting a steady or rising stock price during life of option, and considers the likelihood of a decline very remote. First, the naked put writer has not set aside the cash to buy the stock if assigned. First, the investor could set aside the financial resources to take ownership of the stock at any time if assigned. An uncovered put method expects the put to expire worthless, allowing the writer to keep the premium received at the outset. The maximum gains are very limited, especially relative to the extent of risk. The passage of time will have an extremely positive impact on this method, all other things equal.

The effective purchase price, however, would be reduced somewhat by the premium received from selling the put option. Considering the limited income potential and enormous downside risk, this method is not suitable for most investors. With a lot of luck, the method might work, but an unexpected outcome could be catastrophic. Since the goal is to resell the assigned stock as soon as possible, the delay of a weekend exposes the investor to interim stock price risk, as well as possible inconveniences in bridging the need for cash from option settlement until the subsequent stock sale settlement. At that point, the loss of money would be the strike price, less the initial premium received. Obviously, the higher the strike price, the greater the premium, but the higher the risk of assignment, too.

If the position is still open at expiration, the best that can happen is for the stock price to be above the strike price. In that case, the option expires worthless and the investor pockets the premium received for selling the put option. The potential profit is extremely limited. The best scenario for the put writer would be a steady or rising stock price for the whole term, with no news announcements or other events to trigger greater volatility. The delay between assignment and notification add to the overall risk. There are no guarantees against assignment, short of closing out the put. The only motive for writing an uncovered put is to earn premium income. It requires posting a significant margin to initiate the transaction, but the risk is well in excess of that initial margin, and an unfavorable market move could force the investor to post additional margin on very short notice or to liquidate their position at a substantial loss of money. This method entails a great deal of risk and relies on a steady or rising stock price.

Since the premium constitutes the only benefit, some writers are tempted to write contracts with longer terms and higher strike prices. The maximum theoretical loss of money is limited, but it is very substantial. It does best if the option expires worthless. It is conceivable that the investor might have to incur some additional expenses to come up with enough cash to honor the contract on the settlement day. An increase in implied volatility would have a negative impact on this method, all other things being equal. How can a short put writer reign in the risk of this investment?

This risk applies, too. Look at the covered combo example in Amazon above. In fact, it may tend to get you into less than the best performing. The cost basis for these shares will be the strike price of the put minus the premium that was received for selling the put. In a word, find ways to sell options. Thus, selling naked puts cannot be counted on to get you into the best performing stocks. So what can an options trader do in a high IV environment so that the coming decline in IV works in his favor? Or at least those that decline first before moving up. What if you are you looking for sideways movement in the market?

In that case the investor will be assigned the shares. The picture below shows the risk graph of this trade using Amazon. When you add a naked put sale to a covered write, you get what is called a covered combo. The covered combo is always a fantastic method to use at extreme volatility levels. The drawback to covered writing is that if the stock falls a lot, your short calls do not help cushion the fall beyond a certain point. Also, if a decent rally develops your upside potential is capped by the short calls. Hence, any sensible investor is going to limit his actual risk by only selling a small number of these puts. But, in reality, the factors mentioned above will reduce those expectations.

So, some investors practicing the method would rather sell naked puts than operate a cash covered writing program. So, the question boils down to: can one really expect to make returns of this sort from selling naked puts. But it is certain that our entire account is not going to be invested in this trade, nor is our entire account going to be fully invested at all. It would take a lot of other profitable put writes to make that back. We have written a couple of articles recently on naked put writing and put credit spreads as alternative strategies to covered call writing. In other words, if you want leverage in the covered call method, use naked puts rather than writing covered calls on margin. This article was originally published in The Option Strategist NewsletterVolume 15, No. In other words, over a large number of trials, if one held the position until expiration, he would average a profit of 89 cents on the sale of this put. There will likely be some excess capital sitting in our account at all times. Actually, different investors are going to have different collateral allocations for a method in which naked options are sold.

Once the expected profit has been determined, one can determine the expected return by using his own collateral allocation as the investment. Who is to say that 4 weeks from now, when the HUM puts expire, that there will be another acceptable put sale that offers a similar expected return? First, annualizing can be misleading. You buy car insurance to protect you from a crash. They have identical profit and loss of money profiles. If income is your goal, you should strongly consider using this special form of insurance.

They fail to take a few not difficult steps to insure their investments and protect their wealth. July you keep the entire premium. He also offered some exclusive trade recommendations and answered listener questions. Both are conservative, yet highly profitable, strategies for earning extra and instant payouts from the safest blue chip stocks. Before I go any further, let me explain a little about naked puts. In both strategies, you are exposed to the same limited upside and unlimited loss of money potential. The summer is traditionally the worst six months for individual investors. The method is the only options selling method allowed in retirement accounts. For instance, take covered calls, the safest and most recognized of all options selling strategies.

Even if the investor has sufficient funds in the account to cover the exercise, it can still be classified as naked if the account is approved for naked puts. In this case, the naked put has much lower capital requirements and the cash can be deployed toward other investments. The most that an investor can lose on a naked put is the strike price. The breakeven on a naked put is the strike price minus the premium received. The short side of the put option is required to purchase the underlying stock at the exercise price. Naked puts carry substantially less risk than naked calls, but are still speculative in nature.

The goal of the trade is for the option to expire worthless, in which case the investor keeps the entire premium as a profit. For a naked put, the investor sells a put option and receives a premium in return upfront. To set up a naked put, an investor simply sells a put option. If the stock closes upon expiration at that price, then the losses associated with the trade will exactly offset the upfront premium received. Click the links below! Find out what we look for in a stock, how to put this method on and how to manage this trade effectively when the price of the stock goes up, down and stays the same!

Asktastytrade walks through a Short Naked Put method from beginning to end. Learn more about Naked Options and Put Options! Disclosure: Investment U expressly forbids its writers from having a financial interest in any security they recommend to our subscribers.