Definition
The term naked put refers to a strategy in which the writer of a put option does not own the underlying securities outlined in the contract. Naked puts are considered an advanced options strategy, since they carry considerable risk, which is only second to naked calls.
Explanation
The seller of a put option is referred to as the writer. They are obligated to buy the securities from the holder of the put option if they exercise their right. The buyer of a put pays a fee, known as a premium, to own the right to exercise their option. If the seller of a put does not own a corresponding amount of the underlying security, the option is said to be "naked," which means the seller will have to purchase shares on the open market if the buyer decides to exercise their option.
Generally, the buyer of a put option is bearish on the security, since they believe its price will decrease over time. The writer of the option has a bullish or neutral view in the case of a put. A naked put is considered a very risky option, since the writer is exposed to considerable losses.
There are two possible outcomes when writing a naked put:
Flat Price or Increasing Price: the underlying security's value increases over the term of the option or stays flat, and the buyer of the put does not exercise their right to sell the securities. When this happens, the writer of the naked put profits from the premium they received.
Decreasing Price: the underlying security's value decreases over the term of the option, and the buyer of the put exercises their right to sell the securities. When this happens, the writer of the naked put must purchase the underlying securities at the strike price. While the writer of the naked put still retains the premium they received for writing it, they are also forced to purchase securities at an above-market price.
Related Terms
call option, naked call, covered call, put option
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