Uncovered Put Write

[Igor 10]

An uncovered put write, or a "naked put" as it is frequently called by investors, is an investing strategy which is fundamentally a bet on a stock either staying near its current price or going up. The put in this case is called uncovered because the put writer does not own the underlying stock. Instead, the option trader simply writes put contracts at a strike price and collects the premium. If the stock price stays at or above the strike price to expiration, then the trader collects the premium as profit. However, if the price falls below the strike price, then losses are unlimited (except for the premium) until the stock price reaches zero.

 

 

To see how this works (see diagram) suppose stock XYZ is trading at $45 and the trader writes 1 uncovered put contract at a strike price of $45 for a premium of $2. This would cost $200 for a contract (1 contract=100 shares). If the stock price goes up or stays at $45 all the way to the option expiration date, the trader keeps the premium ($200) as the maximum profit. However, if the price falls below the strike price, then losses depend on the expiration price. For example, if the price at expiration is $40 then the loss would be $5 per share or $500 minus the premium price of $200 for a total loss of $300. Maximum loss would be if the stock price went to $0 which would be $45 per share or $4500 (minus the premium collected).

 

When to use uncovered puts

The best time to use uncovered puts is in periods of low volatility for a stock. If the trader feels there will be little price change in a stock over time, then uncovered puts are a valid strategy. Some traders use these instruments as a major source of income, collecting premiums from expired contracts month-after-month. However, uncovered puts do carry with them a high amount of downside risk if the price of a stock goes down rapidly. Therefore, it is best not to write uncovered puts before an earnings report, expected news release, or any other known factor that could rapidly move the stock price.

 

There is also the risk that if the put is held to expiration, the put will be executed and the put writer will have to take delivery of the stock. The stock could then continue its decline and increase losses. Because of factors such as these, many brokers will not allow traders to write uncovered puts without a substantial amount of capital to serve as security in case of loss.

 

Types of stocks that work well with uncovered puts

The type of stocks that work well with the uncovered put strategy tend to be large, blue chip type stocks that have low volatility and a stable, long-term price trend. It is also wise to choose stocks such as these that are: (1) on a relative uptrend in terms of revenues and earnings or (2) have just been through a strong selloff as a way to hedge against any unforeseen downside price movement.

[kginsberg 10]

Your opening premise, that being a naked put write is a strategy which is a bet on price remaining stable or rising, is, I believe, an incomplete (and therefor inaccurate) description of an uncovered put write.

 

Many people use the uncovered put as an investing strategy to acquire stock at a better price then where it is currently trading. For example, they may feel they would like to own stock ABC, but think it may be overbought at its current price of $50 share. Based on their analysis, they may feel that acquiring ABC at $45 a share would make more sense. They could leave a limit order with their broker at $45 or they could (assuming t hey have the proper option trading permissions) write an uncovered put on the stock with a strike price of $45, They would receive a premium for writing it, and hopefully the stock would fall (albeit temporarily, after all their analysis makes them want to own the stock at $45) to below $45 so it would be put to them at $45 (their cost basis then being $45 minus the premium received for writing the put). If in fact the stock never drops to $45 by the expiration date of the option written, they would not be assigned the stock, but of course would keep the premium anyway. They could then rewrite the put at whatever strike and expiration they thnk is an appropriate acquisition price and start the process anew.

 

To me, if you are going to be using an uncovered put write, one of the first things you need to have established in your analysis, is that you would not mind actually owning the stock at whatever strike price you wrote it at, after all, by writing the put, you have already effectively bought the stock and sold a covered call at the [put] strike price, since the 2 strategies, covered call, and uncovered put write, are synthetically the same, with the same risk/reward profile.