Sorry, no people pictures here.
One of the hardest things to comprehend in the options market is the terminology.
Going “naked” means to have an uncovered position, i.e. not owning the underlying shares. When I sold the “covered call” in my other post “How to make money renting…stocks”, I owned the shares of that particular fund. Therefore, when I sold the option, I was covered against that option.
When I sell an “uncovered” option, I don’t own the underlying shares; therefore, it’s a “naked” position.
So here’s how it works…
Let’s say I want to own XYZ fund. It’s trading at $10 per share, but I want to own it at $9 per share. 1) I can either wait and see if it goes down; 2) buy 100 shares and sell a call against it (covered call) which reduces my cost to $9; or 3) sell a put option.
Selling a put option against shares that I don’t already own is selling a naked put. I have the $900 set aside in a cash account to buy the shares if I get exercised. ($9×100 shares). I get paid $1 for the contract which is the equivalent of $1 per share, or $100. If the fund stays above $9 at expiration, I don’t get to own the shares for $9 but I get to keep the $100. Thus I’ve made $100/$900 = 11% for owning nothing. Pretty neat.
The downside is that if the fund goes below $9, I have to buy the shares at $9, not the current market price. Sounds risky, right? Well, if I had bought them at $10 in the first place and the price went down, I would have lost anyway. So in reality, selling a selling a put option, or a naked put, is really no more risky than buying fund in the first place.
I can use this strategy to lower the cost basis if I already own the fund and want more shares or generate income. If the fund goes up, I didn’t get to buy them at $9, but I did the premium and earn a nice return on my cash.
One very important thing to remember, I only do this on stocks or funds that I absolutely want to own.
Bottom line…I like getting paid and reducing my risk and sometimes I have to get naked to do it.
