Options - Naked Put

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Investing School  Feb 14  Comment 
The term “Naked Put” refers to an instance when an investor is "selling naked," because he or she doesn't actually own the underlying shares. In doing this, the investor assumes the same risk seen when purchasing a stock outright, less the...
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My Trader's Journal  Jul 15  Comment 
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My Trader's Journal  May 26  Comment 
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To perform a "Naked Put" is essentially to short an out of the money put option, short put.

When to use a Naked Put?

An option trader would sell a put option in a particular stock because he/she wants to purchase shares of the stock, but would only allocate a fixed price per share on the stock that is below the intraday stock share price. Essentially the investor is bullish on the stock, but is unwilling to risk more than a fixed amount.

Payoff

An option trader who sells an out of the money put option will receive an option's premium. Chart below from where "K", option's strike price, is marked and going in a rightward direction illustrates the premium received by the trader.

If the put option expires in the money the option trader is obligated to purchase 100 shares of the stock at "K" price, when considering 1 option is equal to 100 shares. The real payoff for the trader is when the stock never goes below or even reaches at "K" price when the option expires. That is because the trader will have received the premium and is not obligated to purchase any shares. However if the stock's price dropped beyond the "K" price plus option's premium the trader received then the end result is an incurred lose because he/she is still required to purchase 100 shares of the stock at exactly "K" price. Hence as illustrated in the chart the diagonal line price action occurring when the stock price is dropping below the "K" strike price.

You can look at a naked put as a less aggressive method to purchasing a stock. A trader is willing to purchase shares of a stock but does not want to purchase the shares at peak prices may consider executing a naked put.

Example

Stock XYZ is at $25.50 in late July 2008.

The Aug 2008 $25 put options are listed with a premium of $1.25.

You were able to execute a sell order on 1 Aug08 $25 put and you received $125 minus commissions at the end of the trade. ($1.25 times 100 shares per an option equals $125.)

On the day the put option you sold expires, the stock XYZ closing price ends at $24.00. The Aug08 $25 put is exercised and you are required to purchase 100 shares at $25/share which totals to $2500+commissions.

For you the end result is a gain. The reason is your premium was slightly more than the difference between the option strike price and the closing price of the XYZ. The difference was $100 but the premium you received was $125.

If XYZ closing price ended anywhere below $23.75 your trade is a lost and if it ended above $25 you would receive maximum profit from the trade, which is the total premium received.

Capital Allocation to exercise a Naked Put

From the example above in order to sell a Aug08 $25 put you should have a minimum of $2500 in your account dedicated to this trade. The reason is because the most you can ever lose in the trade is $2500 minus the premium. This occurs when XYZ stock reaches $0 at Aug08 options expiration date.

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