What is a Naked Put?

A naked put position is where an investor takes an unhedged bullish options position on a stock. The investor sells put options against the stock and collects the premium as cash. Selling the put requires the investor to purchase stock shares should the stock price fall below the strike price of the put option.

Why would you want to do this?

Selling the put option provides cash income. If you sell an out-of-the-money put option and it expires without being executed, you aren't required to purchase shares. You simply receive the cash and have no obligation. If the price falls below the strike at expiration, then you will need to purchase the shares for the strike price.

You can use naked puts to automatically buy stock at a lower price than the current price, while giving yourself the discipline to actually buy when the price drops.  Buy low, sell high.  And ultimately, if the price doesn't drop, you can collect the premium on the puts and wait for an opportune moment to jump in.

Out of the Money Example

Wal-Mart Stores Inc. (WMT) shares currently trade for $52.01.  The April $50 put has a bid price of $0.58.  With $50,000 cash in your account, you could sell ten put options and collect $580 less commissions.  This is about 1% return on your money over the next 43 days.  Annualized, the premium is returning about 8.48% in cash. You are simply waiting for WMT to drop about 4% in price to pick up your shares. 

In the Money Example

Everest Re Group Ltd. (RE) underwrites reinsurance and insurance in the United States (the U.S.), Bermuda, and international markets.  As an insurance company it's abnormal to have shares trading below book value, but this particular insurer trades at 0.76 price to book.   If an investor is willing to buy their shares today, he may consider a naked put position for shares that are in-the-money.  The current price of the stock is $88.28, but if the investor plans on holding through the April 2011 expiration, no matter what, then selling naked puts could lower the entry price.  The $90 April 2011 put option has a bid of $2.90.  So, selling this put would create an obligation to buy shares at a net of $87.10, which is $1.18 less than the current price.