The Naked Truth On Naked Puts (Part 1)

April 3, 2024

Important, Before we get started:
As with any trading strategy, I highly suggest using your platform to paper trade it before you use real money.

This allows you to not only fully understand the strategy, but to work out any kinks with knowing how your platform works, which buttons to push, and so forth.

Now on with the show…

Selling Naked Puts is one of my favorite strategies.

It allows me to use a stock that I believe in to create a cash flow, which is basically my entire trading philosophy.

So what are Naked Puts? And why are they called that?

Well, let’s start with the name. If you read my articles on Covered Calls, you’ll know that the strategy involves:

owning blocks of 100 shares of a stock
and then selling a call that gives someone the right to “call away” that stock from you at a set price

Because you own the stock that you are selling calls against, you are “covered” in case that stock gets called away from you.

With that in mind, let’s look at Naked Puts.

It might help to know that naked puts are also called “uncovered puts.”

When you sell a naked put, you are selling someone the right to “put” that stock to you at a set price.

And because you don’t own the stock you are selling the put against, you are “naked” or “uncovered”…

Meaning that if the stock drops to the strike price of the put you sold, you are on the hook to buy the stock at that price.

That’s essentially the whole strategy.

In short, Naked Puts puts allow you to collect income by selling someone the right to “put” a given stock to you at a set price.

The Big Fear

When I explain this to people, most of the time they’ll nod with excitement.

But then their mind turns to what if?

“What if I’m put the stock?”

That’s a fear that comes from selling Naked Puts on a stock you don’t want to own.

And I’m always quick to tell people that you should NEVER sell Naked Puts on a stock you don’t want to own.

Not only will it mess with your head, causing you to make bad decisions.

But if a stock is truly a dud and keeps sinking, you’re stuck buying it at a bad price as the stock continues going down.

How It Works – An Example

Let’s pick fictional ticker XYZ.

Remember what I always say, before I place a single trade, I always want to check the trend of the stock I’m going to trade.

So that’s the very first step of the Naked Puts strategy: Make sure the stock you are looking to sell puts against is in a nice, long bulllish trend.

Let’s assume XYZ is in a good, bullish trend.

Now I have to look at the options chain to see what price I’d like to own XYZ at.

I pull up an options chain on my computer and look at the side that lists the puts.

This is probably the next most important thing after deciding that you want to trade XYZ stock to begin with.

Because this is when you decide what price you’d be happy to own XYZ at.

Let’s assume XYZ is currently trading at $52.

Scenario 1: If you really want to get assigned the stock, you could get aggressive and sell an in-the-money $55 put that expires in a few days.

That might get you $3.10 or something like that.

Scenario 2: Or if you just want to collect some income while you possibly get it at a cheaper price, you might pick the $50 strike put which gets you 65¢.

Let’s do some math to compare the different outcomes of each of these.

To keep things simple, we’ll set a few ground rules:

We won’t discuss early assignment, which can happen when a put you sold is in-the-money and the buyer of your put decides to assign you the stock before the expiration date
We will assume you are only trading 1 contract, which controls 100 shares

In Scenario 1, you instantly collect $310 for each put that you sell. That’s because each put controls 100 shares. And $3.10 x 100 = $310.

If XYZ’s stock price is anywhere below $55 at expiration, you will be forced to buy 100 shares of the stock at $55 per share.

To find your cost basis, we subtract $55 minus the $3.10 per share that you collected for selling the put, which gives us a cost basis of $51.90.

In Scenario 2, you instantly collect $65 for each put that you sell. Again, because each put controls 100 shares. And 65¢ x 100 = $65.

If XYZ’s stock price stays above $50 (the strike price of the put that you sold) by the expiration date, you will keep that $65 without any further obligation.

If, on the other hand, XYZ’s stock price drops, for example, to $49.75, you will be forced to buy 100 shares of the stock at $50 per share.

And again, we’ll find your cost basis by taking the $50 you bought the stock at and subtracting the 65¢ for the put you sold. This gives you a cost basis of $49.35.

General Rule

The above examples are based on if you really want to get the stock assigned to you.

Notice that we are selling puts either:

in-the-money, meaning that the stock could be assigned to us immediately, if the option buyer chose to do so.
or slightly out-of-the-money, meaning that the stock would have to come down a little bit before we have the possibility of being assigned the stock.

If you are not necessarily trying aggressively to get assigned the stock, here are the general rules I use when selling naked puts:

sell a put 7-10% out-of-the-money (meaning below current market price)
with an expiration date 30-45 days out

You will need to either have the cash in your account to cover purchasing the shares if you are assigned…

OR if you have margin enabled on your account, you only need to have 20%.

Using these general rules, I’ve found that it takes me a while to get assigned, if I ever get assigned at all.

Roundup

In short, there are only two things that can happen when you sell a Naked Put:

the put closes out-of-the-money and expires worthless – in this case, you keep the cash you collected for selling the put and move on with your life
the put closes in-the-money and you are assigned the stock – this is most people’s worst nightmare, but when you pick a solid stock there’s nothing to fear, because all it means is that you collected money up front to buy a stock at a discount. And if, as we expect, that stock continues to rise, you’ve gotten a discount on a winning stock.

Now, make sure you go read the Covered Calls articles I wrote — once you do, you’re on the verge of a powerful discovery.

Because when you combine Naked Puts with Covered Calls, you have two solid strategies that come together to make what some people call an “Income Wheel”.

Here’s a visual to help you understand how they come together.