Understanding the naked put option strategy

Why choose a naked put instead of buying a call or the underlying asset?

Traders may prefer selling naked puts over buying call options or the asset itself for several reasons.

The first reason is the higher probability of profit with naked puts compared to a long call. A long call option only profits if the asset rises above the strike price before expiry, whereas a naked put is profitable as long as the asset does not fall significantly; it can remain flat, rise, or even drop slightly, and the trader still benefits.

Another reason is the opportunity for income generation compared to buying the underlying asset. Instead of purchasing the stock outright, traders can sell puts and earn a premium while waiting for a better entry point. If assigned, the trader buys the stock at the strike price, effectively purchasing it at a discount.

Lastly, the capital requirement for naked puts is lower. Buying the asset outright requires paying the full price upfront, whereas selling a put only requires the margin or cash needed to cover a potential purchase (in the case of a cash-secured put).

Cash-secured put vs naked put: broker limitations

Selling naked puts typically requires a high margin requirement, which may be restrictive for many traders. A more accessible alternative is a cash-secured put, where enough cash is set aside to cover a possible assignment.

A cash-secured put requires a trader to reserve sufficient funds to buy the stock if assigned, making it similar to placing a limit buy order while earning a premium. Whereas a true naked put requires special margin approval from the broker. If the position moves against the trader, the broker may demand additional funds.

For most retail traders, a "naked put" is effectively a cash-secured put due to broker restrictions.

Key considerations when selling a naked put

Before selling a naked put, traders need to evaluate several factors to manage risk and maximise returns:

1. Choosing the right expiration date

Short-term expiration (weekly or monthly puts)

• Faster time decay (theta), which benefits sellers.
• Lower exposure to unexpected market movements.
• More frequent opportunities to collect premiums.

Long-term expiration (leaps or multi-month puts)

• Higher premium collected upfront.
• Greater sensitivity to changes in implied volatility.
• Suitable for traders looking to acquire the asset at a discount in the long term.

2. Selecting the right strike price

At-the-money (atm)

• Higher premium but a greater chance of assignment.

Out-of-the-money (otm)

• Lower premium but a higher probability of expiring worthless.

In-the-money (itm)

• The highest premium but an almost certain assignment if held to expiration.

3. Implied volatility (iv) and market conditions

High iv environments

• Puts are more expensive, meaning higher premium collection.
• Greater risk of sharp price swings.
• Ideal if iv is expected to decline (e.g., after earnings or major events).

Low iv environments

• Lower put premiums, reducing income potential.
• Less risk of sudden price movements.
• More suitable for stable markets.

4. Earnings announcements and market catalysts

Selling puts before earnings

• High iv results in higher premiums.
• Greater risk of a significant price drop if results disappoint.

Selling puts after earnings

• Iv typically drops, making put options cheaper.
• Lower uncertainty about price movement.

Risk and reward of a naked put

If you’re still unsure whether naked puts are a suitable trading strategy for you, let’s take a look at the potential risks and rewards:

Profit potential

The maximum profit you can enjoy from a naked put is the premium collected if the option expires worthless. As such, the best outcome is if the stock remains above the strike price, allowing you to keep the premium without buying the asset.

Risk exposure

A naked put presents three possible risks for a trader:

• Downside risk can be substantial if the stock price drops significantly.
• Assignment risk is possible if the stock falls below the strike price as the trader is forced to buy at that level even if the market price is lower.
• Liquidity risk if the option is thinly traded, meaning that exiting the position may be costly.

Example: selling a naked put on S&P 500 Futures

Let’s consider an example where a trader wants to take a bullish position on S&P 500 Futures, currently trading at 4,500. The trader sells a 4,400 put option expiring in one month for a USD 50 premium. There are three possible outcomes:

1. The market remains above 4,400, resulting in the option expiring worthless and the trader keeping the USD 50 premium as profit. There is no further obligation to buy the asset.
2. The market falls to 4,350, causing the trader to be assigned the contract and to buy the futures at 4,400 (effectively a discount, considering the USD 50 premium received).
3. The market crashes to 4,200, forcing the trader to buy at 4,400 and to incur a substantial loss since the market price is much lower.

Some traders consider selling naked puts as an alternative to chasing a rising market. If they hesitate to buy at current prices due to fear of overpaying or fear of missing out, selling puts allows them to collect a premium if prices remain steady or rise, and to enter the market at a lower price if assigned. This makes the strategy appealing to those who are bullish but cautious about immediate entry.

Pros and cons of selling naked puts

Pros

• Generates consistent income through premium collection.
• Allows future asset acquisition at a discount if assigned.
• Higher probability of profit than buying a call option.
• Requires less capital compared to outright purchase of the asset.

Cons

• Substantial downside risk if the asset price drops significantly.
• Requires a significant margin or cash reserve to cover potential assignment.
• Assignment risk may force the trader to buy the asset at a disadvantageous price.
• Not ideal in high-volatility markets unless the trader has a strong conviction about price direction.

Be prepared

Selling naked puts is similar to running an insurance business—you collect premiums but must be prepared for occasional large losses. For retail traders, naked puts are often structured as cash-secured puts due to broker limitations. By carefully selecting strike prices and expiration dates, traders can optimise risk and return while generating steady income. However, caution is essential in volatile markets to avoid excessive losses.