Uncovered Put Write Explained

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Uncovered Put Write

Writing uncovered puts is an options trading strategy involving the selling of put options without shorting the obligated shares of the underlying stock.

Uncovered Put Write Construction
Sell 1 ATM Put

Also known as naked put write or cash secured put, this is a bullish options strategy that is executed to earn a consistent profits by ongoing collection of premiums.

Limited profits with no upside risk

Profit for the uncovered put write is limited to the premiums received for the options sold and unlike the covered put write, since the uncovered put writer is not short on the underlying stock, he does not have to bear any loss should the price of the security go up at expiration. The naked put writer sells slightly out-of-the-money puts month after month, collecting premiums as long as the stock price of the underlying remains above the put strike price at expiration.

The formula for calculating maximum profit is given below:

  • Max Profit = Premium Received – Commissions Paid
  • Max Profit Achieved When Price of Underlying >= Strike Price of Short Put

Unlimited Downside risk with Little downside protection

While the premium collected can cushion a slight drop in stock price, loss resulting from a catastrophic drop in stock price of the underlying can be huge when implementing the uncovered put write strategy.

The formula for calculating loss is given below:

  • Maximum Loss = Unlimited
  • Loss Occurs When Price of Underlying

Breakeven Point(s)

The underlier price at which break-even is achieved for the uncovered put write position can be calculated using the following formula.

  • Breakeven Point = Strike Price of Short Put – Premium Received

Example

Suppose XYZ stock is trading at $45 in June. An options trader writes an uncovered JUL 45 put for $200.

If XYZ stock rallies to $50 on expiration, the JUL 45 put expires worthless and the trader gets to keep the $200 in premim as profit. This is also his maximum profit and is achieved as long as XYZ stock trades above $45 on options expiration date.

If instead XYZ stock drops to $40 on expiration, then the JUL 45 put expires in the money with $500 in intrinsic value. The JUL 45 put needs to be bought back for $500 and subtracting the initial credit of $200 taken, the resulting net loss is $300.

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Note: While we have covered the use of this strategy with reference to stock options, the uncovered put write is equally applicable using ETF options, index options as well as options on futures.

Commissions

For ease of understanding, the calculations depicted in the above examples did not take into account commission charges as they are relatively small amounts (typically around $10 to $20) and varies across option brokerages.

However, for active traders, commissions can eat up a sizable portion of their profits in the long run. If you trade options actively, it is wise to look for a low commissions broker. Traders who trade large number of contracts in each trade should check out OptionsHouse.com as they offer a low fee of only $0.15 per contract (+$4.95 per trade).

Similar Strategies

The following strategies are similar to the uncovered put write in that they are also bullish strategies that have limited profit potential and unlimited risk.

Naked Put

What is a Naked Put?

A naked put is an options strategy in which the investor writes, or sells, put options without holding a short position in the underlying security. A naked put strategy is sometimes also referred to as an “uncovered put” or a “short put.” The primary use of this strategy is to capture option premium on an underlying security forecast as going higher, but one which the trader or investor would not be disappointed to own for at least a month or maybe longer.

Key Takeaways

  • A naked put is an option strategy that involves selling put options.
  • When put options are sold, the seller benefits as the underlying security goes up in price.
  • Naked refers to an uncovered position, meaning one that has no underlying security associated with it.
  • The risk of a naked put position is that if the price of the underlying security falls, then the option seller may have to buy the stock away from the put-option buyer at a substantial loss based on the strike price the buyer is allowed to sell from.

How a Naked Put Works

A naked put option strategy assumes that the underlying security will fluctuate in value, but generally rise over the next month or so. Based on this assumption, a trader executes the strategy by selling a put option with no corresponding short position in their account. This sold option is said to be uncovered because the initiator has no position with which to fill the terms of the option contract, should a buyer wish to exercise their right to the option.

Since a put option is designed to create profit for a trader who correctly forecasts that the price of the security will fall, the naked put strategy is of no consequence if the price of the security actually goes up. Under this scenario, the value of the put option goes to zero and the seller of the option gets to keep the money they received when they sold the option to begin with.

A seller of put options wants the underlying security to rise, so that they end up profiting. But if the price of the underlying security falls, they may end up having to buy the stock, because the option buyer may decide to exercise their right to sell someone the security. Traders who like this strategy prefer only to do this on underlying securities that they view favorably. If they get the stock put to them, then, if it is a stock they like and see prospects for, they will not mind buying the stock and holding it for a least a month.

As mentioned previously, a naked put option strategy stands in contrast to a covered put strategy. In a covered put, the investor keeps a short position in the underlying security for the put option. The underlying security and the puts are respectively shorted and sold in equal quantities. When executed this way a covered put works in virtually the same way as a covered call strategy, with the primary difference being that the individual executing the covered put strategy expects to profit from the mildly declining price of a security, where a covered call expects to profit from a mildly rising price. That is because the underlying position for covered puts is a short instead of a long position, and the option sold is a put rather than a call.

A naked put strategy is inherently risky because of the limited upside profit potential and, theoretically, a significant downside loss potential. The risk lays in that the maximum profit is only achievable if the underlying price closes merely at or above the strike price at expiration. Further increases in the cost of the underlying security will not result in any additional profit. The maximum loss is theoretically significant because the price of the underlying security can fall to zero. The higher the strike price, the higher the loss potential.

However, in more practical terms, the seller of the options will likely repurchase them well before the price of the underlying security falls too far below the strike price, based on their risk tolerance and stop-loss settings.

Using Naked Puts

As a result of the risk involved, only experienced options investors should write naked puts. The margin requirements are often quite high for this strategy as well, due to the propensity for substantial losses. Investors who firmly believe the price of the underlying security, usually a stock, will rise or stay the same may write put options to earn the premium. If the stock persists above the strike price between the time of writing the options and their expiration date, then the options writer keeps the entire premium minus commissions.

When the price of the stock falls below the strike price before or by the expiration date, the buyer of the options vehicle can demand the seller take delivery of shares of the underlying stock. The options seller will then have to go to the open market and sell those shares at the market price loss, even though the options writer had to pay the options strike price. For example, imagine the strike price is $60, and the open market price for the stock is $55 at the time the options contract is exercised, the options seller will incur a loss of $5 per share of stock.

The premium collected does somewhat offset the loss on the stock, but the potential for loss can still be substantial. The breakeven point for a naked put option is the strike price minus the premium, giving the options seller a little leeway.

Uncovered Option

What is an Uncovered Option?

In option trading, the term “uncovered” refers to an option that does not have an offsetting position in the underlying asset. Uncovered option positions are always written options, or in other words options where the initiating action is a sell order. This is also known as selling a naked option.

Key Takeaways

  • Uncovered options are sold, or written, options where the seller does not have a position in the underlying security.
  • Selling this kind of option creates the risk that the seller may have to quickly acquire a position in the security when the option buyer wants to exercise the option.
  • The risk of an uncovered option is that the profit potential is limited, but the loss potential may generate a loss that is multiple times the greatest profit that can be made.

How an Uncovered Option works

Any trader who sells an option has a potential obligation. That obligation is met, or covered, by having a position in the security which underlies the option. If the trader sells the option but has no position in the underlying security, then the position is said to be uncovered, or naked.

Traders who buy a simple call or put option have no obligation to exercise that option. However those traders who sell those same options do have an obligation to provide a position in the underlying asset if the traders to whom they sold the options do actually exercise their options. This can be true for put or call options.

An uncovered or naked put strategy is inherently risky because of the limited upside profit potential, and at the same time holding a significant downside loss potential, theoretically. The risk exists because maximum profit is achievable if the underlying price closes at or above the strike price at expiration. Further increases in the cost of the underlying security will not result in any additional profit. The maximum loss is theoretically significant because the price of the underlying security can fall to zero. The higher the strike price, the higher the loss potential.

An uncovered or naked call strategy is also inherently risky, as there is limited upside profit potential and, theoretically, unlimited downside loss potential. Maximum profit will be achieved if the underlying price falls to zero. The maximum loss is theoretically unlimited because there is no cap on how high the price of the underlying security can rise.

An uncovered options strategy stands in direct contrast to a covered options strategy. When investors write a covered put, they will keep a short position in the underlying security for the put option. Also, the underlying security and the puts are sold or shorted, in equal quantities. A covered put works in virtually the same way as a covered call. The exception is that the underlying position is a short instead of a long position, and the option sold is a put rather than a call.

However, in more practical terms, the seller of uncovered puts, or calls, will likely repurchase them well before the price of the underlying security moves adversely too far away from the strike price, based on their risk tolerance and stop loss settings.

Using Uncovered Options

Uncovered options are suitable only for experienced, knowledgeable investors who understand the risks and can afford substantial losses. Margin requirements are often quite high for this strategy, due to the capacity for significant losses. Investors who firmly believe the price for the underlying security, usually a stock, will rise, in the case of uncovered puts, or fall, in the case of uncovered calls, or stay the same may write options to earn the premium.

With uncovered puts, if the stock persists above the strike price between the option’s writing and the expiration, then the writer will keep the entire premium, minus commissions. The writer of an uncovered call will keep the whole premium, minus commissions, if the stock persists below the strike price between writing the option and its expiration.

The breakeven point for an uncovered put option is the strike price minus the premium. Breakeven for the uncovered call is the strike price plus the premium. This small window of opportunity would give the option seller little leeway if they were incorrect.

Example of an Uncovered Put

When the price of the stock falls below the strike price before, or by, the expiration date, the buyer of the options product can demand the seller take delivery of shares of the underlying stock. The options seller must go to the open market to sell those shares at the market price loss, even though the option writer paid the strike price. For example, imagine the strike price is $60, and the open market price for the stock is $55 at the time the options contract is exercised. The options seller will incur a loss of $5 per share of stock.

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