Naked Options: Options for Nudists?
Phil Town took an email recently about naked put options. A Rule #1 reader was trying use naked puts to make a little extra money while he waited for a stock to fall to a reasonable MOS (margin of safety) price. It’s an interesting tactic, and Phil has a great response.
Trading strategies are great, but a more pressing issue for me was how this article got me thinking about these so-called naked options. Why are they “naked”?
Here’s the Investopedia definition for a naked put (emphasis mine):
A put option whose writer does not have a short position in the stock on which he or she has written the put. Sometimes referred to as an “uncovered put.”
So when the option’s writer doesn’t own the stock, it’s considered an uncovered (or naked) option. This can make things very risky; be sure to read up thoroughly before braving this type of investment. And then as extra safety, your broker might not even let your make these kinds of trades without signing a bunch of wavers first.
But what is even more risky is having a word document on your laptop titled “Naked Put Options” while your girlfriend is hanging around. To her, that could mean anything.
So where did this term come from? I tried the Oxford English Dictionary and came up short. I then found a neat website WordWizard.com, but that too had no mention of “naked puts” or “naked options”. The best I could come up with was this definition for “naked option” found at Bartleby.com, which cites the American Heritage Dictionary of the English Language: Fourth Edition 2000 (emphasis mine again).
An opening transaction in an option when the underlying asset is not owned by the investor writing the option. If a stock on which such an investor has written a call option is then called by the option holder, the investor must purchase shares in the market for delivery and is therefore caught naked.
I hope you’ve learned something here. Trading options is risky. Trading naked options is riskier.
Selling an option to buy a stock at $20 and then watching that stock sky-rocket to $100 a share is like getting caught with your shirt off and your pants down, or in other words: naked.
UPDATE: The struck-through scenario above is not valid. In that case, the option would expire with the writer collecting the premium. See the comments below for more information. I’ll leave it as an exercise to the reader to come up with a proper “pants down” situation. In any case, you should always…
Be careful.
Other Resources
- Naked Options at Investopedia
- Naked Calls at Investopedia (same idea as naked puts, but the other way around)
- Options Basic Tutorial as Investopedia
39 Comments Add your ownSubscribe
1. Chris | June 21st, 2006 at 11:38 pm
For those who don’t know (I didn’t until I looked it up just now), the writer is the person who is selling the option, i.e. the person who receives money for the option. Typically, mere mortals buy options, i.e. we pay money to the writer/seller.
I don’t understand why being forced to buy a $100 stock for $20 is bad for the writer. Puts are good for buyers when the price drops. So a $50 stock that goes to $20 is a good investment for the buyer, and if the seller has a short position in the stock, makes out as well…
2. homeimprovementninja | June 22nd, 2006 at 3:56 pm
One way to curb your risk, that Phil doesn’t discuss is to do a spread. If the stock is at, say $50 and you sell a put at $40 and buy a put at $30 you should still have some cash out of the deal. (You will have made more from selling at $40 than you did from buying at $30). If the stock falls somewhere between $40 and $30 you do okay by buying a stock that you wanted at a good price. If the stock tanks and falls to $20, then you losses are capped out on anything below $30.
3. Jason | June 22nd, 2006 at 4:20 pm
Great point, Ninja. And that’s one of the best descriptions of a spread I ever read.
4. Random_Walker | June 22nd, 2006 at 10:06 pm
“Selling an option to buy a stock at $20 and then watching that stock sky-rocket to $100 a share is like getting caught with your shirt off and your pants down, or in other words: naked. Be careful.”
The bit above that I have quoted from the article makes absolutely no sense to me whatsoever!
If I sold a naked put option that would require me to buy stock at $ 20 and then the stock skyrocked to $ 100 the option would expire unexcersised/worthless and I as the option writer would actually have made money.
5. Jason | June 22nd, 2006 at 11:23 pm
Nice catch guys. I was confusing things. In the original scenario above, the option would expire and the writer would pocket the premium.
FYI, here is a decent description of naked put selling I found at http://www.callsandputs.com/desc_SellPuts.asp.
“The put buyer is anticipating that the stock price will decrease; the put seller is anticipating that the stock price will stay the same or slightly increase. The put writer (seller) has the obligation to buy the stock at the put strike price should the stock price decrease below the put option strike price. In return for this obligation, the put writer (seller) receives the put option premium. If the stock price increases during the option period, the option will expire worthless and the put writer retains the premium, and he/she is not assigned to purchase the stock at the put option strike price.”
So do people think the “caught naked” analogy is accurate for investors selling uncovered options?
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