Selling naked puts is an options trading strategy. To execute this strategy, the options seller sells put options to a buyer without also short selling the underlying security.

The idea behind this strategy is twofold. First, when you sell the put option, you collect a premium, which serves as income. This works the same as when you sell a call option.

But the second idea is that you can also employ this strategy when you’re interested in owning the underlying security. In this article, we’ll take a closer look at how selling put options works.

How Selling Naked Puts Works

Let’s take a look at how selling naked puts works as an options trading strategy. Let’s say you’re interested in purchasing shares of XYZ stock. However, you would like to see the price of the stock go lower before you buy it.

One way to capitalize on this strategy is to sell naked puts on XYZ stock. When you do this, you immediately collect income – the premium – which is the price that you’re paid for the options sale.

When you sell a put option, you are generally hoping that the price of the stock goes up. If it does, the option will not be exercised and will become worthless. In this case, you get to keep the entire premium as your income.

However, let’s say the price of XYZ stock decreases and the option holder executes the option. Now you must buy shares of XYZ stock from them. However, you were already interested in buying this stock and now you’re getting to do so at a lower price than previously available. This is essentially a win-win for you.

In time, hopefully, the price of the underlying stock will rise and you will be able to sell XYZ stock for a profit. This adds to your total return on selling naked puts as an options strategy.

Selling Naked Puts: An Example

So, how do you go about selling naked puts? Let’s go back to our XYZ stock example. Let’s say XYZ stock has been in a nice uptrend and also hitting close to four-year highs around $29. You’d like to get in and buy some, but you don’t want to buy at its current high price as you feel a pullback is due to happen.

You think XYZ stock may retrace to its 50-day moving average, which is currently around $25. You also think this may happen within the next two months.

At this point, you could be like many other investors and just put in a limit order to buy the stock at $25 and wait to see whether you ever get filled.

Or you can look at XYZ put options and see what they are trading for. As of today, you see that XYZ $25 puts with a strike date in the third week of December had a closing bid of $0.15. If you sell puts, you’ll collect the premium upfront and then two things could happen:

• If the stock stays above $25, the option will likely expire worthless.

• If the stock falls below $25, whoever buys the puts will exercise the option and you’ll get what you wanted… XYZ stock at $25.

When you sell naked puts, for every contract you sell you will get $15 deposited into your account. (There are 100 shares per contract, so $0.15 x 100 = $15.)

What We Want Put Options to Do for Us

If you’ve ever sold put options before, usually the only way you will get assigned on the option is if the underlying security trades below the strike price at expiration. That’s what you’re hoping for in this case.

You want XYZ stock to trade down to $25 so that you get assigned and have 100 shares of XYZ deposited into your account. Since you sold the put option for $0.15, you’re effectively lowering your cost basis to $24.85 per share, whereas the straight stock buyer has to pay $25 per share.

Also, you’re getting paid $15 upfront for your efforts. This goes into your account as income, which will earn interest along with the rest of your available funds. But that’s if you’re right the first time… It can get even better.

Now, if XYZ never trades down to $25 by expiration, what happens? Well, the put buyers won’t exercise, and you won’t get to buy the shares for $25. But you will keep the $15 you were paid for the opportunity. That’s income for you!

And then you can do it again. You can sell puts for the next expiration and see whether you get assigned the shares. If you never get to buy XYZ stock, you have consolation knowing that you’re at least bringing in cash flow.

The Risk in Selling Naked Puts

Now, trading always involves risk, and selling naked puts is no different. In fact, while there is limited upside potential in this strategy, there can be significant downside risk.

This is because the underlying security can fall all the way to zero. The higher the strike price, the more the price of XYZ stock could fall and the more downside risk you potentially face.

Due to the risk involved in selling naked puts, this strategy should be employed only by experienced options traders as this is not a novice strategy. In addition, because of the risk, the margin requirement for this options trading strategy can be relatively high.

Concluding Thoughts on Selling Naked Puts

Selling naked put options is a good strategy when you are slightly bearish on a stock in the short term and wish to own it at a cheaper price. By employing this strategy, you can earn income on the options sale and acquire a stock you like at a cheaper price.

For more great insight on options trading, make sure to sign up for our free e-letter Trade of the Day. It’s packed full of information on strategies like selling naked puts and selling covered calls.

Now that you have a solid understanding of selling naked puts, be sure to keep an eye out for the next article in this options trading series: “American Options.”

Read Next: American Options – What They Are and How They Work