When it comes to the world of Options, nothing is scarier than the term “naked”.
That’s because you’ve probably heard of horror stories where people lost everything trading naked Options like the Naked Put and the Naked Call.
The Naked Put simply means you sell a Put Option where you do not have the funds to fulfill the purchase of 100 shares of the underlying stock in the event it gets exercised.
For example, if you sell a Put Option with a strike price of 100, it means that you’d need $10,000 in capital to fulfill the purchase of 100 shares if it gets exercised.
If you have the $10,000, then it’s considered a Cash Secured Put.
But if you don’t have $10,000, it’s considered a Naked Put.
And if you don’t manage your risk well when trading the Naked Put, you can easily wipe out your account.
But if you use the proper risk management and position size your trades properly, then it can be a very profitable Option trading strategy.
What Exactly Is The Naked Put And How Do You Trade It?
The term “Naked Put” is sometimes synonymous with the term “Short Put”.
That’s because if you have the cash to fulfill the obligations of buying 100 shares at the Put’s strike price, then it would be called a Cash Secured Put.
So for the rest of this guide, I will be using the term “Short Put”.
The Short Put is a premium-selling strategy where you sell a Put Option and receive a premium for it.
It is a neutral to bullish trading strategy, where you expect the price to either go up, sideways, or down a little but not past your strike price.
The diagram above shows the P&L graph for the Short Put.
As you can see, it’s typically a high-probability strategy where the win rate is usually more than 50% (depending on where you choose your strike price).
If you choose a strike price with 30 deltas, your win rate would be approximately 70%.
As you can see on the risk profile, the Short Put has a maximum cap on the profits, but the losses have no cap.
The maximum loss would be if the stock goes all the way to $0.
So the Short Put is an undefined-risk strategy by definition.
Its defined-risk counterpart would be the Short Put Spread (aka Bull Put Spread) because it has a capped risk to the downside.
That means even if the stock goes to $0, all you can lose is the risk you defined for the trade.
So is the Short Put risky compared to the Short Put Spread?
Short Put VS. Short Put Spread (aka Bull Put Spread)
So why would you trade the Short Put at all?
That’s because the Short Put has a higher win rate compared to the Short Put Spread with the same short leg delta.
And the Short Put has pure theta decay as there is no Long Option to negate the theta effects.
Also, the Short Put isn’t necessarily riskier than the Short Put Spread.
That’s because the risk is relative.
Here’s what I mean.
Let’s say, for example, we want to trade the Russell 200o Index ETF (IWM).
And let’s compare trading ONE Short Put versus ONE $5 wide Short Put Spread.
To compare the risk, we would use the Buying Power Requirement (BPR) for the Short Put as the point where we would cut loss.
At this time of writing, the BPR for a 30 Delta Short Put on IWM is approximately $3,000.
That means if the loss of the Short Put trade reaches -$3,000, we would close the trade out for a loss.
And let’s assume we collect $1.50 for the $5 wide Short Put Spread.
That means the maximum loss on the Short Put Spread would be just $350.
If you were to compare these two, obviously the Short Put would seem much riskier than the Short Put Spread.
However, this is like comparing apples to oranges.
That’s because this is not taking into account capital allocation.
Let’s assume you have a rather sizeable trading account and based on your capital allocation, you can risk $3,000 per trade.
In this case, if you chose the Short Put Spread, you wouldn’t trade just one contract.
Instead, you would trade about 8 – 9 contracts to match the $3,000 maximum risk capital allocation.
And if you were to trade the Short Put, you would just trade one contract.
So now we’re comparing apples to apples, and oranges to oranges.
So which is riskier in this case – ONE Short Put or 8 – 9 Short Put Spreads?
Clearly, it’s the Short Put Spreads because it’s easier to hit the maximum loss on the Short Put Spreads than it is to hit the BPR or the Short Put.
All it takes for the Short Put Spread to hit the maximum loss is for IWM to be below the long leg at expiration.
However, for the Short Put to hit the maximum loss at the BPR, IWM has to go much lower than that.
So overall, if you factor in capital allocation, the Short Put is less risky than the Short Put Spread.
How To Trade The Short Put
Here is a guideline on the trade mechanics for trading the Short Put.
Entry:
- Since the Short Put is a neutral-to-bullish strategy, we want to wait till the Stochastic Oscillator shows an oversold signal.
- Ideally, we also want to place the Short Put strike at or below a support level.
Adjustments (optional):
- Method 1: When the strike price / breakeven point is breached, roll out or roll out & down.
- Method 2: At 21 DTE, if the strike price / breakeven point is breached, roll out or roll out & down.
Exit:
- Method 1: Take profit at 50%.
- Method 2: Close trade at 21 DTE regardless of a win or loss.
- Method 3: Take profit at 50% or close trade at 21 DTE, whichever comes first.
Trade Example & Game Plan Walkthrough
This trade example is on GOOGL.
As you can see in the chart above, the Stochastic Oscillator is showing an oversold signal and there’s a support area around $104.
So we want to choose the Short Put strike that is below this support.
On the right-hand side, you can see the available strike price that we can choose.
I chose to sell the 100 strike price which is a 23 delta.
The next step is the most important step in our trading game plan.
And that is to think of all the scenarios that can happen and then plan out your action steps on what to do if each of the scenarios happens.
Many new traders fail to do this and when the trade goes wrong, they have no idea what to do and panic.
If you want to ensure you stay in this game long enough to be profitable, then you must do this step each time you place a trade.
Scenario 1: GOOGL stays above $100.
This would be the best scenario it’s above our strike price and we’re very likely in a profit.
At this point, we can either take profit at 50% of the premium received, or we can wait till 21 DTE to close out the trade.
Scenario 2: GOOGL goes below $100.
This is the scenario that we dread the most because our Short Put would be In-The-Money (ITM) and very likely at a loss.
So at this point, it’s important to plan out what we will do to avoid this one single trade wiping out our trading account.
The first thing to do is to identify where our maximum cutoff point will be.
As mentioned earlier, the maximum cutoff point where we will take a loss is the BPR of this trade.
For this trade, the BPR is approximately $1,250.
So the first action step is to cut loss the moment our Short Put trade reaches a loss of $1,250.
And this $1,250 should be no more than 5% – 7% of our capital.
This is to ensure that we can fight another day and become profitable in the long run.
The next step is to plan what to do if the maximum loss has not been reached.
At this point, there are two things that can be done:
- If there’s more than 21 DTE, then we do nothing. That’s because there’s always a chance that the stock can still go back up.
- If there’s less than 21 DTE, this is where we would consider rolling. Either roll out to the nearest 45 DTE cycle and keep the same strike, or we roll out to the nearest 45 DTE and roll down our strike as well.
To know exactly how to roll, I’ve written an article on rolling Short Puts here.
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