The term “Naked Put” refers to an instance when an investor is “selling naked,” because he or she doesn’t actually own the underlying shares. In doing this, the investor assumes the same risk seen when purchasing a stock outright, less the money received for selling the “naked put” option.
In this situation, an investor may pay $2 for a naked put option [1], which provides the right – which is not mandatory – to sell a certain stock at $50. In this case, the risk is the same as purchasing the stock at $50 minus the $2 for the option, or $48.
In many ways, the potential benefits and risks for a naked put [2] are similar to those of selling covered calls [3] with an owned stock position. Investors who are willing to manage covered calls will usually also be comfortable working with naked puts [2]. The main difference between the two is that a smaller cash payment is required with a naked put.
With the purchase of a stock, there is only profit [4] if the stock moves higher. However, the sale of a naked put can lead to profit whether the stock moves up or down (by a small amount). This means that the sale of naked puts will limit the potential for a total profit, but it does increase the likelihood of making a profit at all.
On the other hand, if a naked put option is exercised, meaning that the put owner chooses to “put” shares at the – much lower – strike price of the option, then the investor is required to purchase the stock.