As you become more and more familiar with options trading, you’re probably starting to look for some different strategies to add to your arsenal of potential profit makers.
For that reason I am going to explain to you today just exactly how the naked put and the naked call strategies can benefit/hurt your profit potential.
By the end of this article you will understand completely how the naked put and naked call works and whether or not it is something that you may want to use in the future.
The Naked Put Introduction
A naked put, or uncovered put, is a position in which the investor writes a put option and has no position in the underlying stock.
Risk is one of the primary concerns when trading the naked put and the naked call.
You technically are exposed to an unlimited amount of risk. The more the stock plummets the more loss you will take on.
You also have a limited amount of profit with this strategy.
The most you can hope to make comes from the premium of the option contract that you wrote.
When should I use the Naked Put?
I always recommend using this strategy on stocks that have been around for a while and are more established in the stock market(Also known as a “blue chip” stock).
The reason for this is because it adds a little layer of security and slightly lessens your potential risk.
Stocks that are established are less likely to go belly up than stocks who are less established.
You also want to find a stock/security that you predict will stay above the strike price at the time of the naked puts options contract expiration date. If you need a review of the basic terminology for options then click here to go to my beginners guide.
If this happens you will receive the full value of the options premium.
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How to use the Naked Put
As I mentioned earlier the the naked put can be risky to use for a limited amount of profit, so we need to look into a couple factors before getting in on a trade with this strategy
Volatility has a negative impact on the outcome of the naked put for the writer of the contract, so make sure the stock/security is not experiencing a high level of volatility.
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.
If time passes and the put remains out-of-the-money, it would be increasingly likely to expire worthless, relieving you of all obligations and giving you the maximum profits.
So make sure to do plenty of research on the security before pulling the trigger.
Another helpful tip to using this strategy successfully is to watch out for contracts with longer terms and higher strike prices.
Both would increase the odds of assignment, which in this case is the exact opposite of what we want to happen.
Example of a Naked Put Trade
Writing an example for options is a little more difficult than other types of markets because we cannot go back and look at how the previous options contracts were written.
So for my examples today we will have to do some hypothetical contracts for options while looking at the price history for a stock.
Let’s take a look at Apple stocks on October 19th of 2017.
I do some looking and find a option contracts that expire in 30 days, have a strike price at $154.00, and give a premium of $1 per share.
So I decide to sell options contracts with those same figures.
Now remember that each contract is for 100 shares and not just for a single share.
That means that at the time of the naked puts expiration date if the price of the Apple is higher than the strike price, I will receive $100 per contract and not $1.
The more contracts you sell the more potential profit you can make and conversely the more risk you open yourself up to by exposing yourself to potentially buying more shares if the market price is lower than the strike price.
Let’s see what happens to the price of Apple as the contract progresses:
What would have happened if it didn’t stay above the strike price of $154.00?
Well I could have been forced to buy 100 shares per contract of the stock and potentially opened myself up to a loss if the stock continued to fall.
You could still make a profit if the stock begins to rise later on as you now own the stock, but again do your research to make sure you don’t hold a losing stock.
Now that we’ve thoroughly uncovered(pun intended) how the naked put works, let’s take a quick look at how to trade the naked call strategy.
The Naked Call
If you recall, I wrote an article a while back on how to trade with the covered call. If you missed and want to check it out here is the link: Click here for my covered call article
The difference between a covered call and a naked call is that the naked call does not already own any of the stock/security when selling the options contract where as covered calls and puts mean you already have some of the security/stock.
A naked call position is usually taken when you expect the stock price to be trading below the option strike price at the time of expiration.
It is important to note that just like the naked put, the maximum possible gain for the naked call is the amount of premium collected when the option is sold.
An example of this would be almost exactly the same as a naked put except that you are wanting the price of the stock to drop instead of rise. So you pretty much just have to reverse what you do in the naked put.
Trading naked puts and naked calls can be attractive when considering the number of potential winning trades versus losing trades.
However, do not be taken in by the lure of easy money, because there is no such thing.
There is a tremendous amount of risk exposure when trading in this manner, and the risk often outweighs the reward.
Certainly, there is potential for profit in naked options and there are many successful traders doing it.
But make sure you have a sound money management strategy and a thorough knowledge of the risks before you consider writing naked options.