When you learn to trade options, you are creating an investment strategy that can be both lucrative and risky. Too often, new investors see the upside potential of options and dive in, head-first. This can lead to disastrous results, especially with new investment apps making options trading easier than ever. However, learning to trade options the right way, and understanding which option strategy is suited to your investor profile can be a great way to compliment your overall portfolio. In our last article, we took a close look at the covered call. Today, we are going to look at the close cousin of the covered call, the naked put.
Selling a naked put (or an uncovered put) involves selling a put option but not holding a short position on the underlying security as you would if you were selling a covered put. With a naked put option, you are selling a put and committing to purchasing stock with funds that you may not have.
Like a covered call, a naked put option can be used to generate income through the option’s premium. When you sell a naked put, you receive a premium from the buyer, which is the current market price of the option. The buyer pays the premium for the right to sell you the shares of the stock any time before expiration at the agreed upon strike price.
The buyer of the put is betting on the stock price going down, but if the stock price goes up and is higher at expiration date, then the option expires worthless and you keep the premium as income. However, if the stock price goes down and the buyer wishes to exercise the option, you (the seller) will be obligated to purchase the stocks you sold.
You may be asking yourself, “How can I sell something that I don’t own? Isn’t that risky?”
Yes, it definitely can be. However, because you are betting on the stock to increase in price in order for the put option to sell worthless, this should be a stock that you wouldn’t mind purchasing as a long-term buy and hold.
This sounds like a lot moving parts and it is. This strategy should only be used for those investors who have taken the time to learn the top option strategies, understand the risk involved, and have had several years of investing experience.
Let’s get a little crazy right now and see how a naked put would work on Tesla (TSLA). Tesla has been on a tear recently but was one of the most shorted stocks in recent history due to its volatile nature, moon-shot type products, and the fact that it has grown over 700% in the past year, giving it a very bubbly feel.
As of today, Tesla is trading around $870 per share. Let’s say that you continue to be bullish on Tesla and feel that Tesla has a lot of room to run and could go up to $1,000 per share in the next 6 months. Being ok with purchasing the stock would be the first pre-requisite to selling a naked put because if the stock price drops during the naked put, the seller would be required to purchase the stocks if the buyer exercises their right to sell the stock.
Now it’s time to sell the naked put. The first step is taking a look at the Put options table for Tesla.
Now we have settled on the put option to sell. This will be at the strike price of $800 on the expiration date of Feb 19, 2020 (about a month from today’s date).
The buyer who purchases this put from you is betting that Tesla’s stock will burst and drop all the way from $870 to $800 during that time and then they will exercise their right to sell you that stock at a much lower price than what you sold them for.
As you can see, the ask price or the premium is $43.40 per share. That means that the buyer will be purchasing the put option for $4,340 ($43.40 * 100 shares). This premium is the income you will receive from selling the naked put option.
Now let’s say that, over the next several weeks, TESLA continues to climb and reaches a price of $900 at the expiration date of Feb 19. This means that selling the naked put option was successful because the price grew instead of decreasing as the buyer of the put was hoping.
You now get to keep the premium of $4,340 and if you held position in Tesla, you would receive a profit of $30 per share.
Now let’s see what would happen if selling the naked put was unsuccessful.
Over the course of the trade, TESLA actually decreased in price and dropped to $790 at the time the option was exercised by the buyer. You would now be required to purchase the stock at a lesser value than what you sold them for, incurring a loss of $10 per share (strike price – current market price).
The Naked Put Option Strategy is inherently risky. As you an see with the example above, the upside potential is limited to the premium received but the loss potential is theoretically much greater.
If selling the naked put is successful and the option expires worthless, the seller would keep the $4,340 premium as income. This is a great return but if the naked put is unsuccessful, the seller could incur steep losses as they would be required to purchase the stocks at a lower price than what they sold them for.
Theoretically, the stock price could go all the way to $0. This would occur if the company went bankrupt and the buyer of the option decided not to exercise the option until it reached $0.
In Tesla’s case, the stock price would drop all the way from $870 to $0 and the seller would incur a loss of $800 per share and be required to purchase the stocks back for $80,000 (yikes).
Now obviously, companies going bankrupt is rare and traders probably wouldn’t have the sense to sell a naked put on a company that has the potential to go bankrupt. But theoretically, this could be the downside of selling a naked put.
In summary:
Investing is inherently risky. Preparing your portfolio with a well-diversified set of stocks, bonds, real estate, and other investment assets can help build a foundation for long-term success. If you are interested in options, taking the time to learn how they work and which strategies are right for you can also contribute to a successful portfolio.
When it comes to selling naked puts, make sure they are in a stock you have faith in and wouldn’t mind purchasing if the naked put does not work out in your favor. As always, do your due diligence and speak to a financial advisor if you have questions or concerns.
Wealthplicity Recent Posts
