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A put option is a contract that gives the buyer the right, but not the obligation, to sell an underlying security to the writer of the option at an agreed-upon strike price within a certain period or on a specific date. American options may be exercised anytime before the expiration date, while European options may only be exercised on the expiration date. If the contract writer does not have an offsetting short position in the underlying stock that the contract is written on, the contract (in this case, "put") writer holds an uncovered position. If the writer has sufficient cash in his account to buy the underlying stock at the strike price, the position is considered a cash-covered put. Writing a naked put with insufficient cash-to-cover is considered risky because the writer could be subject to a margin call upon receipt of an exercise notice.
Payoffs and profits from writing a short put
A naked put (also called an uncovered put) is a put option where the option writer (i.e., the seller) does not have a position in the underlying stock or other instrument. This strategy is best used by investors who want to accumulate a position in the underlying stock - but only if the price is low enough. If the investor fails to buy the shares, then he keeps the option premium as a 'gift' for playing the game.
If the market price of the underlying stock is below the strike price of the option when expiration arrives, the option owner can exercise the put option and force the writer to buy the underlying stock at the strike price. That allows the exerciser to profit from the difference between the market price of the stock and the option's strike price. But if the market price is at or above the strike price when expiration day arrives, the option expires worthless and the put writer profits by keeping the premium collected when the put option was sold.
The potential loss on a naked put can be substantial. If the stock falls all the way to zero, the loss is equal to the strike price minus the premium received. The potential upside is the premium received when selling the option. If the stock price is at or above the strike price at expiration, then the option seller keeps the premium and the option expires worthless. During the option's lifetime, if the stock moves lower, then the option premium may increase (depending on how far the stock falls and how much time passes), and it becomes more costly to close (repurchase the put sold earlier) the position - resulting in a loss. If the stock price completely collapses before the put position is closed, then the put writer can face potentially catastrophic losses.
[edit] References
- Mark D. Wolfinger, "The Rookie's Guide to Options" The Beginner's Handbook of Trading Equity Options" W&A Publishing, Cedar Falls, 2008.
- Investopedia Staff, "Introduction to Naked Puts." "Investopedia" (March 1, 2002)
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