Introduction Naked Put Writing
To write a naked put is simply the shorting of put options without shorting the underlying security.Another way of expressing a naked put writing strategy is to write an uncovered put. The naked put options can be of varied strike prices. However, in this tutorial, we will be discussing writing ATM naked put options.
Motivation
When an investor uses a naked put writing strategy and the price of the underlying security goes down, the put option will expire in the money. When that happens, the writer is obliged to buy the underlying security if the option holder exercises the right to sell. Hence, a long term investor may use an uncovered put write to acquire stock. The premium collected from the sale serves to reduce the purchase price of the underlying security.
The other motivation for doing a naked put writing strategy is to collect premium if the options expire worthless.
Margin requirement
Margin is required to write an uncovered put position as the strategy is perceived to be relatively more risky than buying options outright. The amount of margin required is subject to broker’s discretion.
Steps
Step 1 : Perform economic, fundamental and technical analysis
Step 2 : Outlook – Bullish On The Underlying Security
Step 3 : Study the option chain
Step 4 : Breakeven Analysis
Step 5: Understand Your Profit Zones
Step 6 : Unlimited potential loss
Step 7 : The loss can be calculated as :
Step 8 : Limited profit
Step 9 : Profit calculation of a naked put
Step 10 : Calculate Risk & Reward Ratio
Step 11 : Set Up Trade
Step 12 : Exiting the naked put/uncovered put position
Step 13 : Record Trade In Diary
Step 1 : Perform economic, fundamental and technical analysis
Perform economic analysis, fundamental analysis and technical analysis so that you can be of the opinion that the markets and the underlying security in general is headed up. Some charts patterns that the options trader should look out for are:
Read : Basic Economic Analysis , Basic fundamental Analysis and Introduction to technical analysis
Step 2 : Outlook – Bullish On The Underlying Security
The investor that writes a naked put is bullish on the underlying security. As the price of the underlying security increases, the price of the put decreases. If the put expires worthless and out of the money, the investor gets to keep the entire premium received when writing the naked put. If he writes uncovered puts regularly, it is equivalent to collecting premium as profit consistently.
Step 3 :Study the option chain
It is wise to examine the option chain and identify an appropriate put option to write. At the same time, the trader knows the potential premium or net credit that can be collected by the naked put strategy by looking at the options chain.
Read : Learn to read and understand options chain
Step 4 : Breakeven Analysis
It is important to know where the breakeven point is. Please refer to Step 4 for an explanation of profit zones.
There is one breakeven point on the payoff diagram of a naked or uncovered put.
The breakeven price point = Exercise price of the put – premiums collected from the sale of the put
Step 5: Understand Your Profit Zones
After calculating the breakeven point, the trader is able to determine where the profitable territory is. The profit zone is any price above the breakeven point.
Step 6 : Unlimited potential loss
A loss occurs when the price of the underlying security decreases to an extent that it is less than the difference between the exercise price of the put and the option premium collected from the sale of the put.
Step 7 : The loss can be calculated as :
Exercise price of short put – premium collected – price of the underlying security + commissions paid to the broker
Step 8 : Limited profit
The profit of writing an uncovered put is limited to the amount of premium collected. When the price of the underlying security increases, the price of the put option decreases.On expiry date, if the put option is out of the money, it expires worthless. This is the ideal scenario for the investor.
Step 9 : Profit calculation of a naked put
A profit is realisable when the price of the underlying security is great or equal to the exercise price of the short put.
Maximum profit realisable = Premium received – commissions paid to the broker
Step 10 : Calculate Risk & Reward Ratio
There is a lot of risk for every dollar of reward for a naked put. It is important for a trader to put stop losses in place. Once these stop losses are in place, the trader can calculate an estimated risk and reward ratio. However, if the objective is to acquire the underlying security at a good price, the risk reward ratio should take into account the potential exit price of the underlying security.
Read more : Understanding Risk/Reward Ratio For Option Traders
Step 11 : Set Up Trade
A trader should sell at the money put options with the view that the price of the underlying security will increase over the life of the put option.
Step 12 : Exiting the naked put/uncovered put position
- The best case scenario is when the price of the underlying security rises above the strike price of the put option that is written. When that happens the put option will expire worthless. The options trader gets to keep the entire premium less the brokerage commissions as the maximum profit.
- If the price of the underlying security falls, the trader may want to minimize losses by buying to close a put option with the same expiration and the same strike price. This effectively offsets the uncovered/naked put position.
- If the price of the underlying security falls below strike price of the put, the put will be assigned to the put holder who has the right to exercise the right to buy shares from the put writer. If that right is exercised by the put holder, the put writer has the obligation to buy those shares at the strike price. The put writer can wait for an upswing in price and sell those shares for a profit or choose to sell the shares at a loss.
Step 13 : Record Trade In Diary
Next, record the trade in a diary for the purposes of comparison and reflection. This will help a trader to identify his strengths and weaknesses as a trader and to improve his personal trading algorithm.
Example A Naked Put/Uncovered Put
FGH Company is currently trading at a price of $40. You believe that the price of the company is heading higher in the 12 months due to positive news and stock re-rating. You decide to sell at the money December 40 put at a price of $2.
A month later, the trading price of FGH becomes $50. Your shorted option has expired worthless and you get to keep $200 of option premium without closing out your position.
If the price of the company drops to $30, the investor will suffer a loss. That loss per share is :
$40 – $30 – $2 = $8
The total loss is :
$8 x 100 = $800
Another way to look at it is closing out the put option at a price of $10 which results in a loss of :
$10 – $2 =$8
Hence, the total loss is:
$8 x 100 = $800
Read:
General Overview Of Covered Calls
Execute an In the money covered call
Writing Out-Of-The-Money covered calls
Case Study: Warren Buffet Writing Put Options To Obtain A Lower Stock Purchase Price