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…