If you’ve heard horror stories about selling naked puts, a very risky strategy, and you’re clutching your smelling salts right now, let’s review the difference between selling “cash-secured” puts and “naked” put selling. The latter is a strategy we do not recommend, whereas the former might be a good idea for investors of any level as long as you stay mindful of the risks.
What is a naked put?
First of all, “naked” put selling is not a matter of trading options in a nudist colony. It’s actually a very risky speculative play that should only be undertaken by very seasoned options investors. As we’ve already indicated, if you short a put, the put owner has the right to sell stock to you at the strike price until expiration. In exchange for taking on that potential obligation, you receive the option’s premium.
Let’s say you’re bullish on stock XYZ, so you decide to sell 20 XYZ put contracts to bring in a little extra income. Those 20 put contracts represent the obligation to buy 2,000 shares of the stock, should that obligation be assigned to you. However, if don’t have enough cash in your account and you are forced to buy those 2,000 shares, that’s naked put selling.
You can think of it as the financial equivalent to lowering your completely exposed backside into a pit of highly venomous snakes.
If the stock declines below your strike price, you’d most likely be assigned. Then you’d be forced to buy 2,000 shares of XYZ at a higher price than it’s trading for in the open market. Unless you want to hold on to the shares of this stock, you’d then have to sell the shares at the prevailing market price to recoup at least some of your cash. That would leave you holding the bag for the difference between the strike price and the market price, multiplied by 2,000 shares.
Ultimately, when you sell naked puts, the difference between your strike price and the going market price for the stock could mean substantial losses for you. Selling cash-secured puts on the other hand, is a much less nerve-wracking approach. If you keep enough cash on-hand, not only are you prepared in the event of an assignment, but you’ve tapped into a method to buy stock that may also earn you a little extra income along the way.