Selling Naked Puts
Jul 7, 2010

Selling Naked Puts

Selling naked options is considered to be a risky proposition by most people who understand how options work.  However, there is one situation in which selling an uncovered option is a play I can endorse.

When you sell a call option, you may be obligated to sell 100 shares of stock. Because the price could rise with no potential limit, the risk is unlimited.  In the real world we know that stocks cannot rise without limit, but the prudent investor avoids selling naked calls. It's a strategy for experienced traders.

The situation is similar with naked puts, but there is a significant difference. The put seller may be forced to buy stock, and we know there is a limit on how much can be lost.  The price cannot go below zero.

When would you consider selling naked puts?

This strategy can lose substantial sums in a bear market.  My recommendation is to sell naked put options under only one condition:You want to own the shares and can afford to pay for them.
Let's compare the alternatives:

Buy stock
  • Buy 100 shares of XYZ @ $40 per share. Investment $4,000.
  • Maximum loss $4000
  • Maximum gain, unlimited
Sell put instead of buying stock
  • Sell 1 XYZ Apr 40 put @ $3 and collect $300
  • Maximum gain is $300. (option expires worthless)
  • Earn interest on the cash not used to pay for stock
  • Maximum loss $3,700. (If you are forced to buy the stock @ $40 and it becomes worthless)
When selling puts instead of buying stock, the maximum loss is reduced by the option premium collected.  The bad news is that the maximum gain is limited to that same premium.

Selling puts reduces the risk of stock ownership and is therefore a reasonable alternative to buying stock. If buying stock is the investment you want to make.

Mark D Wolfinger

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