Naked options refers to the strategy of selling a Call or a Put without owning or shorting the stock. The term 'Naked' is used because these are uncovered positions. In both cases, the object of the strategy is to collect the option premium without ever having to buy the underlying stock. An investor will sell an Out-of-the-Money (OTM) Call or Put against a security. The investor wants the option to remain OTM so it expires worthless and the investor will keep the premium. Naked Calls are a Bearish strategy; Naked Puts are a Bullish strategy.
Selling Puts is the more common of the two approaches. First, Puts are written when the market is expected to go up, and the market tends to go up historically more than decline. Calls are written when the market is expected to decline. Secondly, writing a Put is sometimes used as a means of acquiring the underlying stock for less money. When an investor sells (shorts) a Put they are obligating themselves to have the stock Put to them at that strike price if the stock is trading below the strike at expiration. Generally, the stocks selected for selling Puts should be fundamentally sound and poised for growth. A Put seller should have the equivalent of the strike price in reserve, if it should be needed for stock purchase. All of the above discussion is without consideration of margin. Each brokerage firm may have different requirements on the cash needed for security. However, the use of margin just increases the risk / reward and is not recommended or considered in this discussion.
Summary of Naked PUT Strategy
1. Write PUTs only when you are bullish on the stock, index, or market in general.
2. Select candidates whose underlying stock is in an up-trend or has a recent BUY signal.
3. Select candidates whose fundamental outlook is positive and getting better.
4. Generally, the time to maturity should be no more than 2 to 3 months.
5. Diversify your Portfolio with 4 or more different stocks.
6. Out of the money options are most often selected since "in the money" options increase the probability of being exercised, even in a flat market.
Calculations of % Yield Naked
These calculations were developed for those investors that use a naked option selling strategy. If you write naked PUTs, these calculations help evaluate the return if the stock is not assigned to your account. It is assumed that the security for the transaction is cash and the amount of cash is the value of the strike price. In Covered Calls the security for the transaction is the stock purchased, therefore, the price of the stock and the premium are used as the basis. For naked writing, the security is the cash in your account, required by your broker, to potentially purchase the contracted stock for the exercised option. Therefore, the strike price is the security required. This calculation is called "% Yield Naked" and is basically the time premium divided by the strike price expressed as a percent. The formula is:
% Yield Naked = Time Premium ÷ Strike Price
As an example if the current stock price of XYZ is $21 and the May 20 Put had a bid price of $1.00 then:
% Yield Naked (XYZ put) = 1 ÷ 20 = 5.00%
The bid price was used since it is the price received on a market order sale of the option.
For the "in the money" PUT we need to be prepared to buy the stock that is PUT to us at the strike price even though the price is lower. Therefore, for the case where Stock XYZ is selling for $29 and the May 30 PUT is selling for $2.50 bid:
% Yield Naked (XYZ) = Time Premium ÷ Strike Price
% Yield Naked (XYZ put) = 1.50 ÷ 30 = 5.00%
As you can see, the Naked Put Profit and Loss graph looks very similar to the Covered Call risk-reward graph.
The Naked Call strategy is considered to be more risky than the Naked Put strategy. In a Naked Call trade an investor will sell a Call contract obligating themselves to deliver (sell) shares of stock at a set price. Naked Calls are a Bearish strategy, as long as the stock remains below the strike price of the Call, the option expires worthless and the investor keeps the premium. The risk is if the stock goes up. The investor may be forced to buy shares of stock at a much higher price to deliver the stock at the lower strike for a substantial loss. The risk for the Naked Call trade is infinite since, theoretically, the stock could rise in price infinitely. Remember, to satisfy the CALL obligation the stock must be purchased at market price and delivered to the option buyer if exercised at the strike price which is lower than the market price.
The calculation for return for the naked "in the money" call is then based on the price of the underlying stock:
% Yield Naked (XYZ Call) = Time Premium ÷ Stock Price
As an example if the current stock price of XYZ is $31 and the May 30 Call is selling for $2 bid then:
% Yield Naked (XYZ Call) = 1 ÷ 31 = 3.23%